estee lauder 2004ar

THE EST{E L AUDER COMPANIES INC. 767 F IFTH AVENUE NEW YORK, NEW YORK 10153

TH

E EST

{E LA

UD

ER C

OM

PAN

IES IN

C. 2

00

4 A

NN

UA

L REP

OR

T

THECOMPANIES INC.

ANNUAL

EST{E LAUDER

2004

REPORT

THE EST{E L AUDER COMPANIES INC. 2004 ANNUAL REPORT

BRINGING

THE BEST TO

EVERYONE

WE TOUCH

CONTENTS

1

02 Tribute to Mrs. Estée Lauder

04 Portfolio of Brands

08 Chairman’s Message

13 Chief Executive’s Review

34 Board of Directors

35 Officers

36 Financial Highlights

37 Selected Financial Data

38 Consolidated Statements of Earnings

39 Management’s Discussion and Analysis of

Financial Condition and Results of Operations

56 Consolidated Balance Sheets

57 Consolidated Statements of Stockholders’ Equity

and Comprehensive Income

58 Consolidated Statements of Cash Flows

59 Notes to Consolidated Financial Statements

83 Report of Independent Registered Public

Accounting Firm

84 Stockholder Information

THE EST{E LAUDER COMPANIES INC.

The Estée Lauder Companies Inc. is one of the world’s leading manufacturers and marketers of quality skin

care, makeup, fragrance and hair care products. The Company’s products are sold in over 130 countries and

territories under well-recognized brand names, including Estée Lauder, Clinique, Aramis, Prescriptives,

Origins, M.A.C, Bobbi Brown, Tommy Hilfiger, La Mer, Donna Karan, Aveda, Stila, Jo Malone, Bumble and

bumble, kate spade beauty, Darphin, Michael Kors and Rodan + Fields.

THE AMERICAS — The Company was founded by Estée Lauder in 1946 in New York City.

In f iscal 2004, the Americas region represented 55% of net sales and 49% of

operating income.

EUROPE, THE MIDDLE EAST & AFRICA — Our first international door opened in 1960 in

London. In fiscal 2004, Europe, the Middle East & Africa represented 32% of net sales

and 43% of operating income. This region includes results from our travel retail business.

ASIA/PACIFIC — We established a presence in Hong Kong in 1961. In fiscal 2004, the

Asia/Pacific region represented 13% of net sales and 8% of operating income.

02

PHO

TO B

YV

ICTO

R S

KR

EBN

ESK

I

Estée Lauder founded this Company in 1946 armed with four products and an unshakeable belief — that every

woman can be beautiful. By the time she passed away in April 2004, that simple notion had literally changed the

face of the beauty business.

Part of Mrs. Lauder’s legacy is the products and brands she invented. A skin care pioneer, she later became one

of the world’s leading fragrance noses, creating a host of best-selling scents, including the legendary Youth-Dew.

At the same time, Mrs. Lauder was a visionary

businesswoman developing globally successful

brands such as Aramis and Clinique, and pioneering

marketing techniques, including Gift-With-Purchase.

But her real impact was personal. Mrs. Lauder’s leadership inspired thousands of people. She won great respect

both within and outside our industry, and received scores of honors, including the United States Presidential

Medal of Freedom and France’s Legion of Honor. However, Mrs. Lauder was happiest during her in-store

appearances and loved to advise her customers. One of her favorite quotes was “Telephone, Telegraph,

Tell-A-Woman,” based on her conviction that once a woman tried the product, she would like it and share it

with her friends.

Mrs. Lauder formally retired from The Estée Lauder Companies in 1995 but remained deeply devoted to its

products and its people. Each brand the Company developed was as important to her as her namesake line,

and she was proud to watch us grow into a global enterprise that now exceeds $5.7 billion in annual net sales.

That her family should continue in the Company was one of her key wishes, now fulfilled by her grandson, William,

who became President and Chief Executive Officer on July 1, 2004, as well as by her granddaughters, Aerin, who

is Senior Vice President, Global Creative Directions, for Estée Lauder, and Jane, Vice President of BeautyBank.

Her fourth grandchild, Gary, is Managing Director of a private investment firm.

Whether or not you knew her personally, it’s clear that the values we live by and the standards we set for ourselves

are the ones upon which Mrs. Lauder founded this Company 58 years ago. She created a culture of quality,

style and unsurpassed customer service that has made us the global cosmetics leader we are today.

All of us will miss Mrs. Estée Lauder. We will always honor her memory by Bringing the Best to Everyone

We Touch.

03LAUDER

TRIBUTE TOEST{E

BRANDS

PORTFOLIO

04

EST{E LAUDER

Introduced in 1946 . Sold in more than 120 countries and territories .

Technologically advanced and high-performance products with

a reputation for innovation, sophistication and superior quality . Select

products: Perfectionist Correcting Serum for Lines/Wrinkles, Idealist

Skin Refinisher and Idealist Micro-D Deep Thermal Refinisher, Advanced

Night Repair, Electric Intense LipCreme, Pure Color Long Lasting Lipstick,

MagnaScopic Maximum Volume Mascara, Ideal Matte Refinishing

Makeup SPF 8, Estée Lauder pleasures, Beautiful and Estée Lauder

Beyond Paradise.

ARAMIS

Introduced in 1964 and celebrating its 40th Anniversary . Sold in more

than 120 countries and territories . A pioneer in the marketing of prestige

men’s fragrance, grooming and skin care products . Select products:

Aramis Classic, Aramis Life inspired by tennis legend Andre Agassi, and

Day Rescue and Night Rescue by Lab Series for Men.

CLINIQUE


A leading skin care authority, Clinique develops allergy-tested, fragrance-

free products based on the research of guiding dermatologists . Select

products: 3-Step Skin Care System, Perfectly Real Makeup, Moisture

Surge Extra, Total Turnaround Visible Skin Renewer, Repairwear Intensive

Night Cream and Lotion, Active White Lab Solutions, Advanced Stop

Signs Eye Preventative Cream SPF 15, Clinique CX, High Impact Mascara,

Super City Block 25 SPF, Superbalm Lip Treatment, Colour Surge Bare

Brilliance Lipstick, Aromatics Elixir, Clinique Simply, Clinique Happy

and Skin Supplies for Men.

OF

05

PRESCRIPTIVES

Introduced in 1979 . Sold in ten countries and territories . Prescriptives is

the original Exact Match foundation authority . Prescriptives is also known

for its cutting edge doctor-designed skin care . Signature services

include the Colorprinting process and the couture artistry of Custom

Blend Foundation, Powder and Lipstick . Select products: Super Line

Preventor+, Traceless Skin Responsive Tint, Dermapolish System, �magic

Liquid Powder, Virtual Skin Super Natural Finish, False Eyelashes Plush

Mascara, Moonbeam Reflective Gloss . Prescriptives is designed for

All Skins, All Women.

ORIGINS


The Origins mission is to promote beauty and wellness through multi-

sensory products and feel-good experiences . Select products: Peace

of Mind On-the-spot relief, A Perfect World White tea skin guardian,

Ginger Soufflé Whipped body cream and A Perfect World Intensely

hydrating body cream with White Tea . Origins celebrates the connection

between Mother Nature and human nature.

M.A.C

Controlling interest acquired in 1994; acquisition completed in 1998 .

Sold in more than 45 countries and territories . A broad line of color

cosmetics, makeup tools, skin care, foundations, fragrances and

accessories targeting professional makeup artists and fashion-forward

consumers . Select products: Studio Fix Powder Plus Foundation,

M.A.C Paints, M.A.C Lipstick in six formulas and Lipglass . M.A.C

All races, All sexes, All ages.

LA MER

Acquired in 1995 . Sold in more than 30 countries and territories .

La Mer represents supreme luxury and serious treatment . Crème de la Mer,

one of the most innovative and sought-after moisturizers, was developed

by aerospace physicist Dr. Max Huber over 30 years ago . Since then

it has evolved into what can only be described as a legend . La Mer

has expanded from the original, best-selling Crème de la Mer into

a complete range of facial skin care and body products.

BOBBI BROWN


A professional beauty line developed by celebrated makeup artist Bobbi

Brown, encompassing color cosmetics, skin care, professional makeup

brushes, accessories and fragrance . Select products: Foundation Stick,

Creamy Concealer Kit, Lip Color, Lip Gloss, Shimmer Brick Compact,

Extra Skincare, Long-Wear Gel Eyeliner and Bobbi Brown beach.

06

TOMMY HILFIGER

Exclusive global license agreement signed in 1993 . Sold in more than

120 countries and territories . Fragrances and body products that reflect

the all-American lifestyle theme of designer Tommy Hilfiger . Select

products: “tommy,” “tommy girl,” “tommy jeans,” “tommy” and “tommy girl”

Summer Colognes . An agreement in 2004 established Beyoncé Knowles

as the spokesperson for True Star, a new women’s fragrance collection

launching in fiscal 2005.

DONNA KARAN

Exclusive global license agreement signed in 1997 . Sold in more than

120 countries and territories . Luxury fragrance, bath and body collections

that reflect the quality, style and innovation identified with designer

Donna Karan . Select products: Donna Karan Black Cashmere, Donna

Karan Cashmere Mist, DKNY The Fragrance for Women and DKNY

The Fragrance for Men.

AVEDA


Premium professional and consumer hair care, styling, professional hair

color, skin, body and spa, aroma, makeup and lifestyle products based

on the art and science of pure flower and plant essences that fulfill

the brand’s mission of environmental responsibility . Select products:

Full Spectrum Professional Hair Color, Sap Moss Styling Spray, Color

Conserve Foaming Leave-In Conditioner, Shampure Shampoo and

Conditioner, Light Elements, Curessence Damage Relief Shampoo, Hand

Relief and Tourmaline Charged Radiance Fluid.

STILA

Acquired in 1999 . Sold in more than 20 countries and territories . Created

by Hollywood makeup artist Jeanine Lobell, stila is a red carpet favorite .

Select products: Lip Glaze, Illuminating Liquid Foundation, All Over

Shimmer, Convertible Color and Bouquet du Jour . With stylish products

and pretty, shimmery colors, the stila starlet always looks camera-perfect!

Innovative packaging and whimsical illustrations further emphasize stila’s

position as an artistic brand committed to excellence...with a wink.

JO MALONE

Acquired in 1999 . Sold in five countries . Sophisticated yet simple lifestyle

collection of everyday luxuries created by British fragrance and skin

care authority Jo Malone . Select products: Lime Basil & Mandarin

Cologne and Home Candle, Vitamin E Gel, Orange Blossom Cologne

and Grapefruit Scented Home Candle.

07

BUMBLE AND BUMBLE

Controlling interest acquired in 2000 . Represented in more than 15 countries

and territories . A New York-based hair care and education company

with two salons that create quality hair care products distributed through

top-tier salons and prestige retailers . Select products: Curl Conscious,

Surf Spray, Does It All Styling Spray, Hair Powder and Gentle Shampoo.

KATE SPADE BEAUTY

Exclusive global license agreement signed in 1999 . Introduced in

spring 2002 . Sold in specialty and select department stores in the

United States . kate spade beauty is a collection of fragrance, bath and

body products inspired by American handbag designer Kate Spade .

Select products: parfum, eau de parfum, soap trio, buttercream, body

moisturizer and travel vanity . The distinctive fragrance is feminine,

timeless and unexpected — a bouquet of Kate’s favorite white flowers —

complex, yet beautifully tuned.

MICHAEL KORS

Exclusive global license agreement signed and certain assets acquired

in 2003 . Sold in more than 50 countries and territories . The award-win-

ning fashion designer inspired the fragrance Michael Kors, a chic, luxuri-

ous, sexy scent for women, which is a modern interpretation of the classic

tuberose flower . Select products: Michael A Modern Perfume and

innovative Leg Shine, and Michael Kors SHEER Eau de Parfum, an airy

version of the fragrance . Michael Kors for Men fragrance features

selected products such as Eau de Toilette Spray and After Shave Balm.

DARPHIN


A well-established Paris-based brand offering prestige skin care, makeup

and personal care products created from the finest plant extracts and

botanical aromas . Select products: Jasmine Aromatic Care, Stimulskin

Plus Firming and Smoothing Cream, Predermine Cream, Denblan and

Black Mascara.

RODAN + FIELDS

Acquired in 2003 . Sold in the United States and on the Internet .

Rodan + Fields skin care was launched by Stanford University-trained

dermatologists Katie Rodan, M.D. and Kathy Fields, M.D. . Select products:

Calm, Clean and Radiant . The lines offer solutions for specific skin

problems, targeting them with individually packaged, dedicated

regimens trademarked as Multi-Med Therapy. The product line merges

effective over-the-counter medicines with soothing botanicals to offer

proven results.

Dear Fellow Stockholders:

We hope you will take a moment to read the special tribute to Mrs. Estée Lauder, our Company founder, who

passed away at her home in Manhattan this past spring. We chose to honor her in light of the extraordinary

role she played in founding and building this wonderful Company.

I also want to thank so many of you who reached out to our entire family with your sympathy and heartfelt mes-

sages. Our sorrow is tempered by the deep sense of family and incredible optimism that infuses every day

at The Estée Lauder Companies.

Seeing our Company achieve new heights this year and reach for even more audacious goals for our future is

tremendously gratifying. Imagination, agility, caring and courage are core attributes that always advance our work.

NEW PRODUCTS FOR OUR CONSUMERS

Our scientists continue to amaze and delight us. For example, Clinique’s Perfectly Real Makeup utilizes a new

patent-pending mirror technology to create a more natural look. Our rapidly growing, highly exclusive La Mer

introduced The Lifting Face Serum and The Lifting Intensifier, both based on our unique fermentation process and

rare blue algae. The Intensifier boosts the benefits of the Serum and “trains” the skin to look smooth and uniform.

The response to these product introductions — and many others too numerous to name — has been tremendous.

The Company is focused on increasing the number of ownable technologies in our products. We are proud of

our scientific achievements and product development focus.

08

LEONARD A. LAUDER

MESSAGECHAIRMAN’S

New products are the end result of continuous and comprehensive research into ingredients. For example, we are

probing the benefits of essential oils, looking beyond their effects on the sense of well-being and mood. Smelling

the roses to feel more relaxed may actually have a scientific basis. As our colleagues at Origins, Aveda and

Darphin know well, the fragrance of flowers has been a part of relaxation and romance for centuries.

NEW MARKETS FOR OUR BRANDS

Our brands opened in many more markets around the world. They are sold in over 130 countries and territories

worldwide and we continue to bring our newer brands to the international markets. For example, Aveda is now

open for business in Japan, and M.A.C continues to successfully open free-standing stores in Brazil.

Currently, five of our brands — Estée Lauder, Clinique, Aramis, Donna Karan fragrances and Tommy Hilfiger

fragrances — are sold in more than 120 countries and territories, with one — Clinique — sold in more than

130. Still, if we were to introduce all of our brands in every one of these countries and territories, we would

have over 1,300 potential market openings in our future! This provides us with untapped opportunity for

international expansion.

Each time an Estée Lauder Companies brand opens in a new market we are one step closer to becoming a more

truly global Company. I am delighted to report that this year we neared a critical tipping point as our international

sales moved closer to 50% of total sales.

With countries such as Russia, China and India creating vast new middle-class communities, our prospects

abound. Through experience, we know that as women begin to have more disposable income they reach for

the easily attainable, small luxuries of beauty and personal care products. Both Estée Lauder and Clinique are

growing rapidly in the dynamic Chinese market. One clear sign of the emerging Chinese beauty industry is the

development of high-quality women’s fashion magazines. We hosted several of the top Chinese editors at our

headquarters in New York this spring to build relationships with these trendsetters.

NEW VENUES FOR CONSUMERS

First and foremost we must maintain our focus on the rapidly evolving consumer. As the consumer changes, we

must change with her and sometimes lead the way to some very exciting new destinations. State-of-the-art

facilities such as the new Bumble and bumble flagship salon and university in Manhattan’s newly fashionable

Meatpacking District thrill our consumers. The Cooper-Hewitt, National Design Museum, awarded Aveda the

Corporate Achievement Award for exhibiting ingenuity and insight in the relationship between design and

quality of life in its salons.

We never forget the consumer on the move. Our travel retail division continues to flourish as the travel business

has rebounded nicely this year. We also strive to make the in-store experience as engaging and entertaining as

possible. At Jo Malone’s Sloane Street store in London, for example, we offered hand and arm treatments with

edibles to launch Jo Malone’s new coffee fragrance collections. Whether in apothecaries or airports, specialty

stores or online, we seek to touch our consumer in a meaningful way that not only sells products, but builds

brand enthusiasm. Each of these channels allows our consumers to shop where, when and how they choose.

09

THE COMPANY IS FOCUSED ON INCREASING THE NUMBER OF OWNABLE

TECHNOLOGIES IN OUR PRODUCTS.

Our online business, for example, has become a channel-of-choice for a growing number of consumers. This year

our e-commerce business grew 36%. But the real benefit of our Internet activities is the deeper rapport we are

building with our consumers by telling them about new launches and inviting them to the counter.

NEW PEOPLE FOR OUR FAMILY

Our family of companies grows every year. This year we welcomed many wonderful new people to the fold.

We will be working with Doctors Katie Rodan and Kathy Fields, two Stanford-trained dermatologists, in growing

and expanding a highly effective line called Rodan + Fields Multi-Med Therapy. As practicing dermatologists,

Doctors Rodan and Fields witnessed the physical and emotional scars that acne, rosacea, hyperpigmentation

and other skin conditions leave behind. Their mission is to maximize the health and well-being of skin through

products that deliver proven results.

Late in the last fiscal year, we also joined forces with the Paris-based company Laboratoires Darphin. Darphin is

botanical beauty refined to the most sophisticated and advanced level. Darphin has three commitments to its

consumer: targeted personalized skin care treatments, holistic plant benefits and the highest quality ingredients.

Darphin is primarily available in independent European pharmacies, a new distribution channel for us. We are

delighted to have the opportunity to enter these highly professional pharmacies, which are growing more rapidly

than either perfumeries or department stores in Continental Europe.

In this exciting year, we announced the creation of a new division, BeautyBank, a think-tank for new brand

concepts and global business opportunities. In October 2003, BeautyBank’s first project was born. We entered

into a strategic alliance with Kohl’s department stores to build and manage new cosmetic departments for their

stores. We are currently the sole provider of branded cosmetics and skin care for approximately 600 Kohl’s stores.

This fall you will see three new brands developed by our BeautyBank entrepreneurs debuting at Kohl’s:

• American Beauty, a full collection of makeup and skin care celebrating the beauty of American style

• Flirt!, a makeup line with more than 250 shades that encourages the consumer to flirt with the possibilities

• Good Skin,™ a skin care line that is easy to choose, easy to use and doctor-formulated to deliver targeted results

This year we associated ourselves with some very exciting celebrities. Actress Ashley Judd is the ideal

spokeswoman for our new American Beauty brand. We also signed a license agreement to create a

line of fragrances and other beauty products with Sean “P. Diddy” Combs and his Sean John fashion label. Through

his success in music and theater, and by most recently winning the Council of Fashion Designers in America

Menswear Designer of the Year award, Mr. Combs is unquestionably a leading trendsetter of our times.

Additionally, the Tommy Hilfiger Toiletries division created a new fragrance called True Star in cooperation with

superstar Beyoncé Knowles.

THANK YOU TO FRED LANGHAMMER

No discussion of people in our Company would be complete without talking about Fred Langhammer. Fred, a vital

part of our Company for 30 years and our President and Chief Executive Officer for the last four years, decided

to retire at the end of fiscal year 2004.

10

WITH COUNTRIES SUCH AS RUSSIA, CHINAAND INDIA CREATING VAST NEW MIDDLE-CLASSCOMMUNITIES, OUR PROSPECTS ABOUND.

Fred’s contributions to our Company have been monumental. He joined our Company in Japan in 1975 and

was my partner in building this business, taking the Company public and acquiring so many outstanding brands.

Most recently, Fred has done a marvelous job leading our Company during a challenging period of political

and economic uncertainty. He worked with our Board of Directors as they sought his successor and he has

enthusiastically endorsed their selection of William P. Lauder as President and Chief Executive Officer. The Board

of Directors, our colleagues around the world and the Lauder family join me in thanking Fred Langhammer for his

vision, his passion, his integrity and his friendship.

We are fortunate that Fred has agreed to take on the new role of Chairman, Global Affairs. In this capacity,

Fred will leverage his extraordinary knowledge of the global marketplace and deep relationships around the

world to the Company’s advantage.

I am delighted, and of course proud, to see William Lauder become Chief Executive Officer. One of our greatest

competitive assets is the ability to operate as a world-class public Company and keep the spirit of the family

alive for all our employees. I know that William will hold true to the traditions created by Mrs. Estée Lauder and

enhanced by Fred Langhammer during his distinguished service as our Chief Executive Officer.

CONCLUSION

Each section of this letter starts with the word “new.” Our business demands new ideas, new products, new

servicing skills and new opportunities for growth. I am confident that we will continue to find the newest, hottest,

greatest next thing to continue our historic growth.

I am deeply grateful to my colleagues at The Estée Lauder Companies for once again extending our leadership

position in the industry and bringing the very best to our consumers.

We have a bright and exciting future ahead of us.

Sincerely,

Leonard A. Lauder

Chairman

11

FRED’S CONTRIBUTIONS TO OUR COMPANYHAVE BEEN MONUMENTAL...WE ARE FORTUNATE

THAT FRED HAS AGREED TO TAKE ON THE NEW ROLE OF CHAIRMAN, GLOBAL AFFAIRS.

Dear Friends:

At the close of fiscal 2004, I proudly passed the baton to my successor as President and Chief Executive Officer,

William P. Lauder. He has worked closely with me over the last few years and has been a key participant

in formulating strategy and directing the Company. His particular focus on two major factors for success —

building brands and developing talent — is already having an impact. No doubt in his new role, he will lead

The Estée Lauder Companies to new heights.

My years at The Estée Lauder Companies have been tremendously rewarding. I would like to extend my

appreciation to all of our talented employees for inspiring me with their creativity, commitment and passion.

It has been my honor and privilege to work alongside them and to serve as their CEO.

I also would like to recognize and thank our Chairman, Leonard Lauder, who has been my guiding force and

mentor for the past 30 years. I thank the entire Board of Directors for advising us so insightfully through

yet another successful, productive and profitable year. And, finally, I thank each of our stockholders for their

confidence in the strength of our Company and its prospects for growth and value creation.

Sincerely,

Fred H. Langhammer

12

FRED H. LANGHAMMER

Dear Fellow Stockholders:

The hallmarks of a great company are its products, its people and its ideas. By that measure, The Estée Lauder

Companies is truly a great company. Products, people and ideas are the three pillars that have supported our

Company since it was established by our founder, Mrs. Estée Lauder. Although Mrs. Lauder passed away this past

April, her legacy lives on. As the Company completes its 58th year in business, these pillars continue to uphold our

tradition of uninterrupted sales growth.

PRODUCTS and innovation are key drivers in the prestige cosmetics business. We are committed to bringing

the best of both to our consumers. Each year, about one-third of our Company’s sales comes from products that

were launched within the past three years. This year, we introduced more than 300 new products around the

world. Their strength has been recognized not only by our largest year-over-year sales gain ever, but also by

the numerous honors they were awarded. In North America, we were pleased to receive 11 CEW Beauty

Awards from Cosmetic Executive Women for outstanding new products — one of the industry’s top honors.

Innovation remains the driving force that propels our Company forward. Our innovation and skill in product

development come from more than 400 scientists in six Research & Development Centers around the world. They

are constantly working with leading research institutions seeking the latest insights into skin care and makeup

technologies. Our goal is to find the best ideas around the world, nurture them and bring them to consumers in

the form of outstanding products.

The second pillar is the PEOPLE who drive the Company. Our success depends upon people with curiosity,

creativity, passion and energy. These words certainly describe the employees of The Estée Lauder Companies.

From the scientists at our R&D Centers who keep us on the leading edge of innovation to the people in

Operations who ensure that we have a highly efficient supply chain producing and delivering the best products

to stores around the globe to the artists who create the exciting visual merchandising you see at the counters that

13

REVIEW

FRED H. LANGHAMMER WILLIAM P. LAUDER

CHIEF EXECUTIVE’S

display some of the best packaging in the industry — we have it all. Our Chairman, Leonard Lauder, said it best:

“The wealth of a company is its people. By that standard, we are a very wealthy company.”

Our financial success may be measured by sales and profits, but our overall success is measured by the power

and promise of our IDEAS. Our Company has always been known for its vision: We were the first cosmetics

company to connect with consumers by providing samples and Gift-With-Purchase; we were the first to

introduce consistent brand imagery around the world, and we were the first major prestige cosmetics company

to offer shopping on the Internet.

At present, our innovative drive is best exemplified by the creation and launch of several new brands in Kohl’s

department stores. This summer, we announced the fall launch of three new brands for Kohl’s — American

Beauty, Flirt! and Good Skin.™ The investment in these brands will enable us to reach consumers who might

not otherwise shop in our traditional channels of distribution with unique offerings. The venture will also provide

us with a range of products positioned to appeal to consumers in emerging markets around the world.

The effort is being directed by our new division, BeautyBank, an incubator for new brand concepts and global

business opportunities.

FINANCIAL HIGHLIGHTS

Our critical assets — our products, our people and our ideas — contributed to an outstanding performance in

fiscal 2004. We added an unprecedented $694.4 million to top-line sales, generating $5.79 billion in total net sales,

an increase of 14% over last year. Net earnings attributable to common stock were $342.1 million, compared

with $296.4 million in fiscal 2003 representing a 15% increase. And, diluted earnings per common share increased

17% to $1.48, compared with $1.26 in the prior year.

The results were driven by several outstanding accomplishments:

• Global sales growth • Resource management

• Growth in our four main product categories • Strong distribution dynamics

GLOBAL SALES GROWTH

Our performance around the world certainly benefited from increased travel and tourism, recovery in the prestige

distribution channel and the effects of a weaker U.S. dollar.

On a regional basis, in the Americas, annual net sales increased 7% to $3.15 billion. In Europe, the Middle East &

Africa, annual net sales increased 24% to $1.87 billion. On a constant currency basis, net sales in that region rose 14%.

And in Asia/Pacific, annual net sales rose 17% to $771.4 million, while net sales in constant currency grew by 9%.

Outside the developed markets, we solidified our presence in fast-growing emerging markets. We relocated our

Asian regional headquarters to Shanghai and also developed the blueprint for a new R&D Center in China.

Our business in Russia continued to show strong growth, and other Eastern European markets continue to

show promise for the future.

GROWTH IN OUR FOUR MAIN PRODUCT CATEGORIES

Strong growth was reported in our four main product categories, led by fragrance and makeup. Two of our

categories, skin care and makeup, reached milestones this year, with both exceeding $2 billion in sales for the first

time in our history. Net sales in fragrance were $1.22 billion, up 15% on a reported basis and 10% in constant

currency. The improvements were driven by the resurgence of the travel retail channel, where 60% of

the cosmetics sales in the channel are generated by fragrance, as well as several new launches — including

Estée Lauder Beyond Paradise, Aramis Life and Clinique Simply.

14

INNOVATION REMAINS THE DRIVING FORCETHAT PROPELS OUR COMPANY FORWARD.

Net sales in makeup were $2.15 billion, up 14% on a reported basis and 10% in constant currency. Growth was

led, in part, by the continued momentum of our two leading makeup artist brands — M.A.C and Bobbi Brown.

Furthermore, both Clinique and Estée Lauder made strong progress in the mascara segment, with Clinique gaining

significant share in this important category around the world and Estée Lauder receiving the prestigious award

for the best new eye product from Cosmetic Executive Women for MagnaScopic Maximum Volume Mascara.

Foundation also continued to show strong sales in North America, Europe and Asia for Clinique and Estée Lauder.

Skin care net sales, which benefited from heightened interest in anti-aging and other technologically-advanced

products, were $2.14 billion, an increase of 13% on a reported basis and 8% in constant currency. Our two core

brands — Estée Lauder and Clinique — each posted strong results in the category, supported by new products like

Idealist Micro-D Deep Thermal Refinisher and Hydra Complete Multi-Level Moisture Crème by Estée Lauder and

the Pore Minimizer line of products from Clinique. Skin care was also strengthened by the inclusion of two new

brands — Darphin and Rodan + Fields — and by the rapid growth of one of our cult brands, La Mer.

Our performance in hair care was led by strong growth in our two salon brands, Aveda and Bumble & bumble,

which continue to distinguish themselves with high quality products and by leading the prestige hair care category

with cutting-edge ideas in training for styling techniques and salon management. Overall, net sales in hair care for

the year grew 9% to $249.4 million on a reported basis and 7% in constant currency.

RESOURCE MANAGEMENT

In fiscal 2004, we continued to place strong emphasis on managing our resources wisely. Cost savings from our

Global Operations group improved our profitability and eliminated inefficiencies, allowing us to re-deploy

resources to areas that directly impact the consumer and drive top-line growth. For example, cost of goods

as a percentage of net sales improved 50 basis points over last year as a result of supply chain initiatives and

reductions in promotional spending in favor of advertising. Reported operating expenses, as a percentage of net

sales, improved 70 basis points due in part to savings in selling, distribution and administration costs.

STRONG DISTRIBUTION DYNAMICS

On the distribution front, we experienced continued recovery and growth in the profitable travel retail channel

following its two-year slump. Our own freestanding retail stores also performed well, as did our e-commerce

business. Finally, and perhaps most noteworthy, we saw a terrific recovery in domestic department stores as well as

a particularly strong recovery in high-end specialty retailers like Neiman Marcus, Nordstrom and Saks Fifth Avenue.

LOOKING AHEAD

As we begin a new chapter in the Company’s history, we look forward to your continued support. Going into

this year, we will maintain our focus on building talent and building brands — the two catalysts that will take us

to the next level.

Thank you, stockholders, for your belief in our brands, our Company and our people.

Sincerely,

Fred H. Langhammer William P. Lauder

15

TWO OF OUR CATEGORIES, SKIN CARE ANDMAKEUP, REACHED MILESTONES THIS YEAR,

WITH BOTH EXCEEDING $2 BILLION IN SALESFOR THE FIRST TIME IN OUR HISTORY.

Estée Lauder showcases its dynamic fragrance brands in adeluxe travel retail setting in theU.S. Virgin Islands.

FRAGRANCE

17

The legacy of Estée Lauder evokes fragrant recollections of Youth-

Dew, the very first scent of The Estée Lauder Companies. Youth-Dew

broke the stereotype not only of how to sell a fragrance, but of what

a fragrance could be. As the first bath oil that doubled as a perfume,

Youth-Dew became a pillar of innovation that has set the standard for

The Estée Lauder Companies’ approach to fragrance development:

Innovate, don’t imitate.

In a year that saw the number of new fragrance introductions from

all companies reach an all-time high, our brands maintained their

leadership. All in all, The Estée Lauder Companies markets more

than 70 different fragrances, many of which have been consumer

favorites for more than ten years.

Overall, our brands had five of the top ten best-selling fragrances in

United States prestige department stores in fiscal 2004. International

markets hold untapped opportunities for our fragrances, as the

Company’s brands are currently under-represented in Europe and

travel retail. The strength of our fragrance launches, as well as

the rebound in travel retail, added buoyancy to our fragrance sales

this year.

“THE LINGERING SCENT OF A BEAUTIFUL WOMAN AS SHE PASSES BYIS ONE OF THOSE MEMORIES THAT LIVE FOREVER.”

— EST{E LAUDER

18

In a category where newness is the catalyst that drives interest, several

of our brands successfully introduced winning scents.

Estée Lauder introduced Beyond Paradise — a fragrance built on a

unique collaboration with the Eden Project, the world’s largest nature

conservancy, where essential oils are developed exclusively for the

Estée Lauder brand. Within the first six months of sales, Estée Lauder

Beyond Paradise found its place among the top five fragrances in U.S.

department stores.

Clinique Simply defined the new category of “modern oriental” and

reflected the consumer trend towards comforting, modern classics.

It joined Clinique Happy, Clinique Happy Heart and Aromatics Elixir

by Clinique as a truly original scent. Happy Heart quickly captured

hearts as it became the number one addition to the Clinique Happy

franchise, while Aromatics remains a top seller in Continental Europe

and the United Kingdom.

Aramis launched Aramis Life with Andre Agassi, bringing new life to

the men’s fragrance category and capturing the Cosmetic Executive

Women award for best new men’s fragrance in 2004. At the same

time, Aramis Classic celebrated 40 years as a classic men’s fragrance.

Celebrity cachet added an aspirational touch to our designer

fragrances. Tommy Hilfiger Toiletries announced a new scent, True

Star, with Beyoncé Knowles, while we also announced a licensing deal

with Sean John, a fashion company founded by Sean “P. Diddy”

Combs, to develop Sean John fragrances.

19

Core fragrances such as Donna Karan Cashmere Mist, DKNY,

Estée Lauder pleasures, Estée Lauder’s Beautiful, “tommy” and

“tommy girl” continue to be strong sellers at retail. Black Cashmere

by Donna Karan has become a prestige fragrance-of-choice for

the sophisticated consumer.

Jo Malone had a strong year both in the United States and the United

Kingdom, opening a new shop on prestigious Madison Avenue in

New York City as the lifestyle fragrance brand continues to develop its

loyal following. Designer fragrance Michael Kors continued to sell

selectively around the world, reflecting the influence of fashion

on fragrance.

Our fragrance teams partner closely with Research & Development to

explore new ways of infusing fragrance into products. Research on

essential oils and their effects is helping the Company’s fragrances

connect with consumers in new ways. With the help of technology

and innovation, we are developing new structures for fragrances and

expanding the realm of emotions they evoke. Continuing to sell

fragrance today will mean understanding the constantly changing

dynamics that define the marketplace and the customer, and

redefining the rules of how we market fragrances to consumers.

20

M.A.C brings makeup excitementto Latin America with its first free-standing store in Brazil.

21

Makeup continues to be a strong category for the Company. Whether

it’s mascara, foundation, eye shadow, lip gloss, powder or blush, our

leadership is clear. In the United States, eight of the top ten best-

selling makeup products sold in cosmetic departments of prestige

department stores in fiscal 2004 belonged to our portfolio of brands.

Going forward, there is ample opportunity for our brands to replicate

our U.S. success in the international markets.

Clinique excels as the number one prestige foundation brand in the

world anchored by its line of eight high-performance foundations.

Estée Lauder’s Pure Color lip and nail line continues to grow inter-

nationally and is leading the brand’s renewal in the makeup category.

Success in the makeup category in fiscal 2004 was driven by launches

of Perfectly Real Makeup, High Impact Mascara and High Impact

Eye Shadow from Clinique, as well as Electric Intense LipCreme and

Ideal Matte Refinishing Makeup SPF 8 by Estée Lauder.

In fiscal 2004, our brands excelled in mascara — one of the industry’s

most competitive segments. Estée Lauder’s MagnaScopic Maximum

Volume Mascara, Clinique’s High Impact Mascara and M.A.C’s Fibre

“THE MOST BEAUTIFUL FACE IN THE WORLD...IT’S YOURS.”— EST{E LAUDER

MAKEUP

22

Rich Lash Mascara each held top rankings. Recognizing that not all

lashes are created equal has led Estée Lauder to develop 11 different

formulas to meet the needs of women around the world, while

Clinique has nine innovative formulas.

Sales growth also reflects the impact of makeup artist brands M.A.C

and Bobbi Brown. M.A.C continued to build its professional team of

makeup artists who developed trend setting looks at over 400 fashion

shows around the world. M.A.C Viva Glam lipstick has helped

to raise more than $35 million over the last 10 years for the M.A.C

AIDS Fund. The introduction of Viva Glam V generated precedent-

setting sales during its six-week launch period.

Bobbi Brown expanded the power of makeup artistry by creating a

worldwide team of artists called Bobbi’s Beauty Team. These experts

embody Bobbi Brown’s philosophy of making women of all ages feel

confident about themselves by celebrating the women they are. Bobbi

Brown Shimmer Brick, Bobbi Brown Foundation Stick and Long-Wear

Gel Eyeliner are some of the brand’s leading products. This year, the

brand introduced its sixth foundation — Smooth Skin Foundation.

23

Stila is gaining traction as the brand-of-choice among Hollywood

insiders. Illuminating Liquid Foundation and Stila Lip Glaze were

both chosen by Sephora clients as “The Best of Sephora”, making

the brand the only one to win in two categories. Stila’s innovative

packaging is known worldwide for its whimsical style.

Anti-aging advancements such as optical technology, mirror

technology and micro-pigments have boosted the importance of

makeup’s role in fighting lines and wrinkles. New products take

advantage of this new-age technology to do more than cover. Multi-

benefit products such as foundation with sunscreen, foundations that

balance and foundations that moisturize are being launched by

brands like Clinique, whose Perfectly Real Makeup provides micro-

mirrored technology that optically resurfaces skin for a perfect color

match; Estée Lauder, whose Ideal Matte Refinishing Makeup SPF 8

protects and covers, and Bobbi Brown, whose Extra SPF 25 Tinted

Moisturizing Balm teams a touch of color with hydration for an

all-natural looking complexion.

24

SKIN

25

Anti-aging, dermatologist brands, high technology, performance

luxury and advanced sun protection are the top-line drivers in skin

care this year. Skin care sales have been supported by a baby boomer

population that is increasingly interested in staying youthful looking

and staving off the outward signs of aging. Anti-aging products

glowed as one of the fastest growing segments in the skin care

category, as did the emerging trend in dermatologist-developed

brands. Six corporate global Research & Development Centers work

continuously to develop a higher level of understanding of the effects

of aging on skin, conducting studies around the world in order to

create products that bring high-tech benefits to consumers.

Our brands introduced several new products targeted toward

consumers looking for advanced benefits. Estée Lauder successfully

launched Estée Lauder Idealist Micro-D Deep Thermal Refinisher,

an alternative to micro-dermabrasion, and Estée Lauder Hydra

Complete Multi-Level Moisture Crème, which provides the latest in

skin moisturization.

“AGE IS AN IRRELEVANCY TO EVERY WOMAN. GLOW IS THE ESSENCEOF BEAUTY — IT’S THE ABSENCE OF RADIANCE THAT DIMINISHESBEAUTY AT ANY AGE.”

— EST{E LAUDER

CARE

26

Clinique reinforced its skin authority this year with the launch in the

United States of Clinique CX Redness Relief Cream and Clinique CX

Rapid Recovery Cream, high-end products specially formulated to

care for sensitive, stressed or delicate skin. In addition, Clinique added

to its Repairwear line with Repairwear Day SPF 15 Intensive Cream

and Repairwear Intensive Eye Cream.

In the performance luxury niche, La Mer continued to build loyalty

among consumers with the introduction of its new The Lifting Face

Serum and The Lifting Intensifier, while Estée Lauder’s Re-Nutriv line

of products experienced dynamic growth around the world.

In the dermatologist-developed segment, Prescriptives continues

to launch skin care products that bring the benefits of a doctor’s

knowledge to skin care. The addition of Rodan + Fields to our

portfolio provides an added level of credibility to our skin care

expertise. Created by two practicing dermatologists, Dr. Katie Rodan

and Dr. Kathy Fields, the line offers solutions for skin-specific

problems, merging effective over-the-counter medicines with

soothing botanicals.

Darphin’s Stimulskin Plus Firming and Smoothing Cream and

Stimulskin Plus Eye Contour Cream bring high quality natural

ingredients and a select blend of pure essential oils to women seeking

the benefits of aromatherapy in skin care. Darphin also provides

entrée into independent European pharmacies — Continental Europe’s

fastest-growing skin care channel.

27

In the wellness arena, Origins continues to benefit from strong sales of

its A Perfect World line, as well as new launches Calm to Your Senses

and No Puffery Cooling mask for puffy eyes. Origins Peace of Mind

epitomizes the essence of the brand, as it fulfills the consumer’s desire

for serenity and calmness.

Understanding the damaging effects of UVA radiation has generated

a series of top-level industry events and product launches. Clinique

sponsored a symposium at the IX International Congress of

Dermatology in China. Titled “New Developments in Sun Protection:

From SPF Towards IPF,” it focused on the effects of UVA radiation on

the skin’s defense system. Both Estée Lauder and Clinique have

launched whitening products developed specifically for the Asian

consumer to treat the effects of sun on delicate Asian skin — Estée

Lauder White Light EX and Clinique Active White Lab Solutions.

Sun protection was a focus for brands such as Bobbi Brown which

introduced its Beach Suncare line, and Estée Lauder, which introduced

Daywear Plus Multi-Protection Anti-Oxidant Crème SPF 15.

28

Aveda opens its first Japaneseflagship in Tokyo, winning “Store ofthe Year” for its authentic design.

29

The hair care category sustains its momentum, contributing continuous,

solid sales growth. Our professional salon brands, Aveda and Bumble

and bumble, are favorites with beauty professionals and consumers

alike. Breakthrough product technology, consistent performance by

existing offerings, new doors and exclusive salons and educational

centers deepen the relationships that both brands have with

their customers.

Last September, Aveda opened its first Lifestyle Salon and Spa in

Japan, where there is extraordinary potential for development in hair

care. In addition to the salon and spa, there is a retail store and café.

The new Lifestyle Salon and Spa will be the cornerstone of the brand’s

expansion throughout the country. Aveda also launched its Berlin

Institute, modeled after the brand’s highly successful facilities in

Minneapolis, New York City and London. Complete with an Academy

where beauty professionals are trained in advanced hair techniques

and a Lifestyle Salon, the new Institute supports Aveda’s business in

Germany and elsewhere.

“BEAUTY IS THE BEST INCENTIVE TO SELF-RESPECT.”— EST{E LAUDER

HAIRCARE

30

Bumble and bumble premiered its new headquarters in New York

City’s trendy Meatpacking District in April. The multi-use space

includes the brand’s second salon for consumers, offices and Bumble

and bumble University. This “graduate school” offers courses to

salon owners, managers and stylists who want to refresh their cutting,

coloring and styling talents, as well as to hone business skills such as

strategic and financial management, retailing and customer service.

Important product launches also contributed to hair care’s growth in

fiscal 2004. Aveda’s Damage Remedy Shampoo and Conditioner,

created to address the special challenges faced by Asian hair, became

the top-sellers in Japan and will roll out globally next year. The brand

also launched Scalp Benefits Shampoo and Conditioner, formulated to

address scalp concerns, and Pure Abundance Volumizing Shampoo

and Volumizing Clay Conditioner, which combine kaolin clay and

certified organic acacia gum to help fine hair look fuller and feel

thicker. New styling offerings included Light Elements Detailing

Mist-Wax, a lightweight product that creates definition and

separation, and Air Control, a hairspray that delivers flexible, lasting

hold without harming Earth’s climate. Hair color, particularly the

brand’s Color Current Energized Gel Color and Full Spectrum

Deposit-Only Color Treatment, continued to be a leading source of

sales for salons.

31

Bumble and bumble launched two 3-step systems in the Curl

Conscious line: one for fine-to-medium hair and one for medium-to-

thick hair. Consisting of Shampoo, Conditioner and Curl Crème, the

products give hair hold and shine while creating defined curls that

are resistant to heat and humidity. The brand also introduced Extra

Strength Holding Spray, which provides structure and control while it

delivers moisture and flexibility, and reduces fly-aways.

Beyond salons, hair care is part of our business strategy in prestige

department and specialty stores and an important category for our

Company-owned retail stores. Clinique is a leading hair care brand in

United States department stores with products like Gentle Wash

Shampoo, Healthy Shine Serum and Shaping Wax, among others,

while Clear Head Mint Shampoo and Rich Rewards Intensive

treatment for scalp and hair are a significant part of Origins hair care

business. Donna Karan’s Cashmere Mist Shampoo and Conditioner

continued to attract consumers, while Bobbi Brown launched its first

hair care entry, Bobbi Brown beach Leave-in Hair Conditioner SPF 15.

32

Estée Lauder models Liya Kebede,Elizabeth Hurley and CarolynMurphy are featured together forthe first time for the Future PerfectAnti-Wrinkle Radiance Crème ad campaign.

PROMOTION

33

Being in the right place at the precise moment consumers look for

beauty information is crucial in this era of hyper-communication.

Our brands take a leading position in all media while relying on

advertising, public relations, special events and promotions to

continually build excitement at the counter. Estée Lauder launched its

new fragrance, Beyond Paradise, with a dazzling campaign that

brought sensuality and fantasy into the fragrance category.

In Asia, Clinique launched a revolutionary campaign targeted

specifically to the sensibilities of Asian women.

Special events are another way our brands reach out. The M.A.C

Pro Team worked at over 400 fashion shows this year, doubling their

international appearances. A hip-hop promotion in Japan was so

successful that the M.A.C counters became a destination as a trend-

setting brand. M.A.C introduced Viva Glam V with a star-studded

team of five celebrities, raising $1.7 million for the M.A.C AIDS Fund.

Niche brands like Jo Malone and Rodan + Fields connect with

consumers by hosting home parties for opinion leaders and appearing

at local events.

Celebrities help to keep our brands aspirational. Estée Lauder,

added a new dimension to its ads this year by featuring Elizabeth

Hurley, Carolyn Murphy and Liya Kebede together in an icon shot.

Beyoncé Knowles will be the inspiration and the image for the new

True Star fragrance by Tommy Hilfiger.

In-store appearances by Jeanine Lobell for Stila and the Bobbi Brown

makeup artists add glamour and excitement to the counters.

“TELEPHONE, TELEGRAPH, TELL-A-WOMAN.”— EST{E LAUDER

ANDADVERTISING

34

CHARLENE BARSHEFSKY3

Senior International PartnerWilmer Cutler Pickering Hale and Dorr LLP

ROSE MARIE BRAVO2,4

Chief ExecutiveBurberry Group Plc.

1 Member of Audit Committee

2 Member of Compensation Committee(NOTE: Ms. Bravo will replace Mr. Rose on November 5, 2004)

3 Member of Nominating and Board Affairs Committee

4 Member of Stock Plan Subcommittee(NOTE: Ms. Bravo will replace Mr. Rose on November 5, 2004)

RICHARD D. PARSONS 2,3

ChairmanChief Executive Officer

Time Warner Inc.

MARSHALL ROSE 2,4

ChairmanThe Georgetown Group

BARRY S. STERNLICHT 1

ChairmanChief Executive Officer

Starwood Hotels & Resorts Worldwide, Inc.

LYNN FORESTER DE ROTHSCHILD 1,2,3,4

Chief Executive OfficerELR Holdings, LLC

IRVINE O. HOCKADAY, JR.1

Retired President andChief Executive OfficerHallmark Cards, Inc.

LEONARD A. LAUDER3

ChairmanThe Estée Lauder Companies Inc.

RONALD S. LAUDERChairmanClinique Laboratories, Inc.

Private Investor

WILLIAM P. LAUDERPresident Chief Executive OfficerThe Estée Lauder Companies Inc.

BOARD OFDIRECTORS

35

OFFICERS

MALCOLM BOND

Executive Vice President

Global Operations

PATRICK BOUSQUET-CHAVANNE

Group President

DANIEL J. BRESTLE

Group President

ANDREW J. CAVANAUGH

Senior Vice President

Global Human Resources

HARVEY GEDEON

Executive Vice President

Research & Development

RICHARD W. KUNES


Chief Financial Officer

EVELYN H. LAUDER

Senior Corporate Vice President

LEONARD A. LAUDER

Chairman

RONALD S. LAUDER

Chairman

Clinique Laboratories, Inc.

WILLIAM P. LAUDER

President

Chief Executive Officer

SARA E. MOSS


General Counsel and Secretary

CEDRIC PROUVÉ

Group President

International

PHILIP SHEARER

Group President

SALLY SUSMAN


Global Communications

THE ES T{E L AUDER COMPANIES INC. 36

F INANCIAL HIGHLIGHTS

* Fiscal 2003 information includes the effect of a special charge of $22.0 million ($13.5 million after tax), or $.06 per diluted common share, related to theproposed settlement of a legal action. Fiscal 2002 information includes the effect of restructuring charges of $117.4 million or $76.9 million after tax (of which $0.5 million after tax was included in discontinued operations) or $.32 per diluted common share. Fiscal 2001 information is reported after considering the effect of restructuring and special charges of $63.0 million ($40.3 million after tax), or $.17 per diluted common share,and after the cumulative effect of adopting a new accounting principle in the amount of $2.2 million after tax, or $.01 per diluted common share. For amore detailed description of our operating results, including the impact of these items, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

† In February 2004, we sold the assets and operations of our former reporting unit that sold jane brand products. As a result, fiscal 2004, 2003 and 2002information has been restated to reflect that reporting unit as discontinued operations.

A HERITAGE OF UNINTERRUPTED SALES GROWTH

1953 1972 1985 1991 2004$100 million $1 billion $2 billion $5.8 billion

NET SALES*†

(Dollars in billions)

4.44 4.67 4.71 5.10 5.79

2000 2001 2002 2003 2004

OPERATING INCOME*†

(Dollars in millions)

515.8 495.6 342.1 503.7 644.0

2000 2001 2002 2003 2004

NET EARNINGS FROMCONTINUING OPERATIONS*†


314.1 305.2 212.9 325.6 375.4

2000 2001 2002 2003 2004

PercentYEAR ENDED JUNE 30 2004 2003 Change(Dollars in millions, except per share data)

Net Sales† $5,790.4 $5,096.0 14%

Operating Income*† 644.0 503.7 28%

Net Earnings from Continuing Operations*† 375.4 325.6 15%

Net Earnings Per Common Share from Continuing Operations — Diluted*† 1.62 1.29 26%

AT JUNE 30Total Assets $3,708.1 $3,349.9 11%

Stockholders’ Equity 1,733.5 1,423.6 22%

THE ES T{E L AUDER COMPANIES INC.

SELEC T ED F INANCIAL DATA

The table below summarizes selected financial information. For further information, refer to the audited consolidatedfinancial statements and the notes thereto beginning on page 56 of this report.

YEAR ENDED OR AT JUNE 30 2004 2003 2002 2001 2000(In millions, except per share data)

STATEMENT OF EARNINGS DATA:Net sales(a) $5,790.4 $5,096.0 $4,711.5 $4,667.7 $4,440.3Gross profit(a) 4,314.1 3,771.6 3,451.0 3,441.3 3,202.3Operating income 644.0 503.7 342.1 495.6 515.8Interest expense, net(g) 27.1 8.1 9.8 12.3 17.1Earnings before income taxes, minority interest,

discontinued operations and accounting change(b) 616.9 495.6 332.3 483.3 498.7Provision for income taxes 232.6 163.3 114.7 174.0 184.6Minority interest, net of tax (8.9) (6.7) (4.7) (1.9) —Discontinued operations, net of tax(c) (33.3) (5.8) (21.0) — —Cumulative effect of a change in

accounting principle, net of tax — — — (2.2) —Net earnings(b) 342.1 319.8(d) 191.9(e) 305.2(f) 314.1Preferred stock dividends(g) — 23.4 23.4 23.4 23.4Net earnings attributable to common stock(b) 342.1 296.4(d) 168.5(e) 281.8(f) 290.7

CASH FLOW DATA:Net cash flows provided by operating activities $ 669.8 $ 553.1 $ 519.3 $ 305.4 $ 442.5Net cash flows used for investing activities (208.0) (192.5) (217.0) (206.3) (374.3)Net cash flows used for financing activities (216.0) (555.0) (123.1) (63.5) (87.9)

PER SHARE DATA:Net earnings per common share from

continuing operations(b) (c):Basic $ 1.65 $ 1.30(d) $ .80(e) $ 1.19(f) $ 1.22Diluted $ 1.62 $ 1.29(d) $ .79(e) $ 1.17(f) $ 1.20

Net earnings per common share(b):Basic $ 1.50 $ 1.27(d) $ .71(e) $ 1.18(f) $ 1.22Diluted $ 1.48 $ 1.26(d) $ .70(e) $ 1.16(f) $ 1.20

Weighted average common shares outstanding:Basic 228.2 232.6 238.2 238.4 237.7Diluted 231.6 234.7 241.1 242.2 242.5

Cash dividends declared per common share $ .30 $ .20 $ .20 $ .20 $ .20

BALANCE SHEET DATA:Working capital $ 877.2 $ 791.3 $ 968.0 $ 882.2 $ 716.7Total assets 3,708.1 3,349.9 3,416.5 3,218.8 3,043.3Total debt(g) 535.3 291.4 410.5 416.7 425.4Redeemable preferred stock(g) — 360.0 360.0 360.0 360.0Stockholders’ equity 1,733.5 1,423.6 1,461.9 1,352.1 1,160.3

(a) Effective January 1, 2002, we adopted Emerging Issues Task Force (“EITF”) Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer.” Upon adoption of thisIssue, we reclassified revenues generated from our purchase with purchase activities as sales and the costs of our purchase with purchase and gift with purchase activities as cost of sales,which were previously reported net as operating expenses. Operating income has remained unchanged by this adoption. For purposes of comparability, these reclassifications have beenreflected retroactively for all periods presented.

(b) Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” financial results for periods subsequent to July 1, 2001 excludegoodwill amortization. Goodwill amortization included in fiscal 2001 and 2000 was $20.9 million ($13.4 million after tax) and $17.6 million ($11.1 million after tax), respectively.Excluding the effect of goodwill amortization in these same periods, diluted earnings per share would have been higher by $.06 and $.05, respectively.

(c) In December 2003, we committed to a plan to sell the assets and operations of our former reporting unit that sold jane brand products and we sold them in February 2004. As a result,all consolidated statements of earnings information in the consolidated financial statements and footnotes for fiscal 2004, 2003 and 2002 has been restated for comparative purposesto reflect that reporting unit as discontinued operations. Earnings data of the discontinued operation for fiscal 2001 and 2000 is not material to the consolidated results of operationsand has not been restated.

(d) Net earnings, net earnings attributable to common stock, net earnings per common share from continuing operations and net earnings per common share for the year ended June 30, 2003 included a special charge related to the proposed settlement of a legal action of $13.5 million, after tax, or $.06 per diluted common share.

(e) Net earnings, net earnings attributable to common stock, net earnings per common share from continuing operations and net earnings per common share for the year ended June 30, 2002 included a restructuring charge of $76.9 million (of which $0.5 million was included in discontinued operations), after tax, or $.32 per diluted common share, and a one-time charge of $20.6 million, or $.08 per common share, attributable to the cumulative effect of adopting SFAS No. 142, “Goodwill and Other Intangible Assets,” which is attributableto our former reporting unit that sold jane brand products and is included in discontinued operations.

(f) Net earnings, net earnings attributable to common stock, net earnings per common share from continuing operations and net earnings per common share for the year ended June 30, 2001 included restructuring and other non-recurring charges of $40.3 million, after tax, or $.17 per diluted common share, and a one-time charge of $2.2 million, after tax, or$.01 per diluted common share, attributable to the cumulative effect of adopting SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”

(g) During fiscal 2004, there was an increase of approximately $17.4 million in interest expense, net and a corresponding decrease in preferred stock dividends as a result of theadoption of SFAS No. 150 (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recently Issued Accounting Standards”). Additionally, inconnection with this pronouncement, redeemable preferred stock has been reclassified as a component of total debt subsequent to June 30, 2003. The provisions of SFAS No. 150 didnot provide for retroactive restatement of historical financial data.

37


CONSOLIDAT ED S TAT EMEN TS OF EAR NINGS

YEAR ENDED JUNE 30 2004 2003 2002(In millions, except per share data)

Net Sales $5,790.4 $5,096.0 $4,711.5Cost of sales 1,476.3 1,324.4 1,260.5

Gross Profit 4,314.1 3,771.6 3,451.0

Operating expenses:Selling, general and administrative 3,651.3 3,225.6 2,982.8Restructuring — — 109.6Special charges — 22.0 —Related party royalties 18.8 20.3 16.5

3,670.1 3,267.9 3,108.9

Operating Income 644.0 503.7 342.1Interest expense, net 27.1 8.1 9.8

Earnings before Income Taxes, Minority Interest and Discontinued Operations 616.9 495.6 332.3

Provision for income taxes 232.6 163.3 114.7Minority interest, net of tax (8.9) (6.7) (4.7)

Net Earnings from Continuing Operations 375.4 325.6 212.9Discontinued operations, net of tax (33.3) (5.8) (21.0)

Net Earnings 342.1 319.8 191.9Preferred stock dividends — 23.4 23.4

Net Earnings Attributable to Common Stock $ 342.1 $ 296.4 $ 168.5

Basic net earnings per common share:Net earnings attributable to common stock from continuing operations $ 1.65 $ 1.30 $ .80Discontinued operations, net of tax (.15) (.03) (.09)

Net earnings attributable to common stock $ 1.50 $ 1.27 $ .71

Diluted net earnings per common share:Net earnings attributable to common stock from continuing operations $ 1.62 $ 1.29 $ .79Discontinued operations, net of tax (.14) (.03) (.09)

Net earnings attributable to common stock $ 1.48 $ 1.26 $ .70

Weighted average common shares outstanding:Basic 228.2 232.6 238.2Diluted 231.6 234.7 241.1

See notes to consolidated financial statements.

38


MANAGEMEN T’S DISCUSSION AND ANALYSIS OF F INANCIAL CONDIT ION AND R ESULTS OF OPERAT IONS

39

CRITICAL ACCOUNTING POLICIES AND ESTIMATESThe discussion and analysis of our financial condition andresults of operations are based upon our consolidatedfinancial statements, which have been prepared in con-formity with U.S. generally accepted accounting princi-ples. The preparation of these financial statementsrequires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenues andexpenses reported in those financial statements. Thesejudgments can be subjective and complex, and conse-quently actual results could differ from those estimates.Our most critical accounting policies relate to revenuerecognition; concentration of credit risk; inventory; pen-sion and other postretirement benefit costs; goodwill andother intangible assets; income taxes; and derivatives.

REVENUE RECOGNITIONGenerally, revenues from merchandise sales are recordedat the time the product is shipped to the customer.We report our sales levels on a net sales basis, which iscomputed by deducting from gross sales the amount ofactual returns received and an amount established foranticipated returns.

As is customary in the cosmetics industry, our practiceis to accept returns of our products from retailers if prop-erly requested, authorized and approved. In acceptingreturns, we typically provide a credit to the retailer againstsales and accounts receivable from that retailer on adollar-for-dollar basis.

Our sales return accrual is a subjective critical estimatethat has a direct impact on reported net sales. This accrualis calculated based on a history of gross sales and actualreturns by region and product category. In addition, asnecessary, specific accruals may be established for futureknown or anticipated events. As a percentage of grosssales, sales returns were 4.6%, 5.1% and 4.8% in fiscal2004, 2003 and 2002, respectively.

CONCENTRATION OF CREDIT RISKAn entity is vulnerable to concentration of credit risk if it isexposed to risks of loss greater than it would have had itmitigated its risks through diversification of customers.The significance of such credit risk depends on the extentand nature of the concentration.

We have three major customers that owned and oper-ated retail stores that in the aggregate accounted for$1,253.8 million, or 22%, of our consolidated net sales infiscal 2004 and $166.6 million, or 25%, of our accountsreceivable at June 30, 2004. These customers sell productsprimarily within North America. Although management

believes that these customers are sound and creditworthy,a severe adverse impact on their business operationscould have a corresponding material adverse effect onour net sales, cash flows and/or financial condition.

In the ordinary course of business, we have establishedan allowance for doubtful accounts and customer deduc-tions in the amount of $30.1 million and $31.8 million asof June 30, 2004 and 2003, respectively. Our allowancefor doubtful accounts is a subjective critical estimate thathas a direct impact on reported net earnings. Theallowance for doubtful accounts was reduced by $25.6million, $30.3 million and $24.8 million for customerdeductions and write-offs in fiscal 2004, 2003 and 2002,respectively, and increased by $23.9 million, $31.5 millionand $28.6 million for additional provisions in fiscal 2004,2003 and 2002, respectively. This reserve is based uponthe evaluation of accounts receivable aging, specificexposures and historical trends.

INVENTORYWe state our inventory at the lower of cost or fair marketvalue, with cost being determined on the first-in, first-out(FIFO) method. We believe FIFO most closely matchesthe flow of our products from manufacture through sale.The reported net value of our inventory includes saleableproducts, promotional products, raw materials andcomponentry and work in process that will be sold orused in future periods. Inventory cost includes raw mate-rials, direct labor and overhead.

We also record an inventory obsolescence reserve,which represents the difference between the cost of theinventory and its estimated market value, based on vari-ous product sales projections. This reserve is calculatedusing an estimated obsolescence percentage applied tothe inventory based on age, historical trends and require-ments to support forecasted sales. In addition, and as nec-essary, we may establish specific reserves for futureknown or anticipated events.

PENSION AND OTHER POSTRETIREMENTBENEFIT COSTSWe offer the following benefits to some or all of ouremployees: a domestic trust-based noncontributorydefined benefit pension plan (“U.S. Plan”); an unfunded,nonqualified domestic noncontributory pension plan toprovide benefits in excess of statutory limitations; a con-tributory defined contribution plan; international pensionplans, which vary by country, consisting of both definedbenefit and defined contribution pension plans; deferredcompensation; and certain other postretirement benefits.


The amounts necessary to fund future payouts underthese plans are subject to numerous assumptions andvariables. Certain significant variables require us to makeassumptions that are within our control such as an antici-pated discount rate, expected rate of return on plan assetsand future compensation levels. We evaluate theseassumptions with our actuarial advisors and we believethey are within accepted industry ranges, although anincrease or decrease in the assumptions or economicevents outside our control could have a direct impact onreported net earnings.

The pre-retirement discount rate for each plan used fordetermining future net periodic benefit cost is based on areview of highly rated long-term bonds. For fiscal 2004,we used a pre-retirement discount rate for our U.S. Planof 5.75% and varying rates on our international plans ofbetween 2.25% and 6.00%. For fiscal 2004, we used anexpected return on plan assets of 8.00% for our U.S. Planand varying rates of between 3.25% and 7.50% for ourinternational plans. In determining the long-term rate ofreturn for a plan, we consider the historical rates of return,the nature of the plan’s investments and an expectationfor the plan’s investment strategies. The U.S. Plan assetallocation as of June 30, 2004 was approximately 63%equity investments, 32% fixed income investments, and5% other investments.

For fiscal 2005, we will use a pre-retirement discountrate for the U.S. Plan of 6.00% and anticipate using anexpected return on plan assets of 7.75%. The net changein these assumptions from those used in fiscal 2004 willcause a de minimis decrease in pension expense in fiscal2005. We will continue to monitor the market conditionsrelative to these assumptions and adjust them accordingly.

GOODWILL AND OTHER INTANGIBLE ASSETSGoodwill is calculated as the excess of the cost ofpurchased businesses over the value of their underlyingnet assets. Other intangible assets principally consist of purchased royalty rights and trademarks. Goodwill and other intangible assets that have an indefinite life arenot amortized.

On an annual basis, we test goodwill and otherintangible assets for impairment. To determine the fairvalue of these intangible assets, there are many assump-tions and estimates used that directly impact the resultsof the testing. We have the ability to influence theoutcome and ultimate results based on the assumptionsand estimates we choose. To mitigate undue influence,we use industry accepted valuation models and setcriteria that are reviewed and approved by various levelsof management.

INCOME TAXESWe account for income taxes in accordance with State-ment of Financial Accounting Standards (“SFAS”) No. 109,“Accounting for Income Taxes.” This Statement establishesfinancial accounting and reporting standards for theeffects of income taxes that result from an enterprise’sactivities during the current and preceding years.It requires an asset and liability approach for financialaccounting and reporting of income taxes.

As of June 30, 2004, we have current net deferred taxassets of $145.9 million and non-current net deferred taxliabilities of $26.8 million. The net deferred tax assetsassume sufficient future earnings for their realization, aswell as the continued application of currently anticipatedtax rates. Included in net deferred tax assets is a valuationallowance of approximately $4.2 million for deferred taxassets, which relates to foreign tax loss carryforwards notutilized to date, where management believes it is morelikely than not that the deferred tax assets will not be real-ized in the relevant jurisdiction. Based on our assess-ments, no additional valuation allowance is required. If wedetermine that a deferred tax asset will not be realizable,an adjustment to the deferred tax asset will result in areduction of earnings at that time.

Furthermore, we provide tax reserves for Federal, stateand international exposures relating to audit results,planning initiatives and compliance responsibilities. Thedevelopment of these reserves requires judgments abouttax issues, potential outcomes and timing, and is a sub-jective critical estimate.

DERIVATIVESWe account for derivative financial instruments in accor-dance with SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities,” as amended, whichestablishes accounting and reporting standards for deriv-ative instruments, including certain derivative instrumentsembedded in other contracts, and for hedging activities.This Statement also requires the recognition of all deriva-tive instruments as either assets or liabilities on thebalance sheet and that they be measured at fair value.

We currently use derivative financial instruments tohedge certain anticipated transactions and interest rates,as well as receivables and payables denominated in for-eign currencies. We do not utilize derivatives for tradingor speculative purposes. Hedge effectiveness is docu-mented, assessed and monitored by employees who arequalified to make such assessments and monitor theinstruments. Variables that are external to us such associal, political and economic risks may have an impacton our hedging program and the results thereof.

40

THE ES T{E L AUDER COMPANIES INC.41

RESULTS OF OPERATIONSWe manufacture, market and sell skin care, makeup, fragrance and hair care products which are distributed in over 130countries and territories. The following table is a comparative summary of operating results for fiscal 2004, 2003 and2002 and reflects the basis of presentation described in Note 2 and Note 18 to the Notes to Consolidated FinancialStatements for all periods presented. Products and services that do not meet our definition of skin care, makeup, fragranceand hair care have been included in the “other” category.

In February 2004, we sold the assets and operations of our reporting unit that sold jane brand products. Prior to the saleof the business, in December 2003, we committed to a plan to sell such assets and operations. At the time the decisionwas made, circumstances warranted that we conduct an assessment of the tangible and intangible assets of the janebusiness. Based on our assessment, we determined that the carrying amount of these assets as then reflected on ourconsolidated balance sheet exceeded their estimated fair value. In accordance with the assessment and the closing of thesale, we recorded an after-tax charge to discontinued operations of $33.3 million for the fiscal year ended June 30, 2004.The charge represents the impairment of goodwill in the amount of $26.4 million; the reduction in value of other tangi-ble assets in the amount of $2.1 million, net of taxes; and the reporting unit’s operating loss of $4.8 million, net of tax.Included in the operating loss of the fiscal year were additional costs associated with the sale and discontinuation of thebusiness. All consolidated statements of earnings information for the prior years presented have been restated forcomparative purposes, including the restatement of the makeup product category and the Americas region data.

YEAR ENDED JUNE 30 2004 2003 2002(In millions)

NET SALESBy Region:

The Americas $3,148.8 $2,931.8 $2,846.0Europe, the Middle East & Africa 1,870.2 1,506.4 1,261.1Asia/Pacific 771.4 657.8 610.6

5,790.4 5,096.0 4,717.7Restructuring* — — (6.2)

$5,790.4 $5,096.0 $4,711.5

By Product Category:Skin Care $2,140.1 $1,893.7 $1,703.3Makeup 2,148.3 1,887.8 1,758.3Fragrance 1,221.1 1,059.6 1,017.3Hair Care 249.4 228.9 215.8Other 31.5 26.0 23.0

5,790.4 5,096.0 4,717.7Restructuring* — — (6.2)

$5,790.4 $5,096.0 $4,711.5

OPERATING INCOMEBy Region:

The Americas $ 319.2 $ 255.3 $ 222.8Europe, the Middle East & Africa 274.4 227.7 179.9Asia/Pacific 50.4 42.7 56.0

644.0 525.7 458.7Restructuring and Special Charges* — (22.0) (116.6)

$ 644.0 $ 503.7 $ 342.1

By Product Category:Skin Care $ 336.3 $ 273.2 $ 248.4Makeup 257.7 206.6 183.1Fragrance 24.8 32.1 13.4Hair Care 23.6 14.8 13.7Other 1.6 (1.0) 0.1

644.0 525.7 458.7Restructuring and Special Charges* — (22.0) (116.6)

$ 644.0 $ 503.7 $ 342.1

*Refer to the following tables and discussion for further information regarding these charges.


The following table presents certain consolidated earnings data as a percentage of net sales:

YEAR ENDED JUNE 30 2004 2003 2002

Net sales 100.0% 100.0% 100.0%Cost of sales 25.5 26.0 26.8

Gross profit 74.5 74.0 73.2

Operating expenses:Selling, general and administrative 63.1 63.3 63.3Restructuring — — 2.3Special charges — 0.4 —Related party royalties 0.3 0.4 0.4

63.4 64.1 66.0

Operating income 11.1 9.9 7.2Interest expense, net 0.4 0.2 0.2

Earnings before income taxes, minority interest and discontinued operations 10.7 9.7 7.0Provision for income taxes 4.0 3.2 2.4Minority interest, net of tax (0.2) (0.1) (0.1)

Net earnings from continuing operations 6.5 6.4 4.5Discontinued operations, net of tax (0.6) (0.1) (0.4)

Net earnings 5.9% 6.3% 4.1%

RECONCILIATIONS OF FINANCIAL RESULTSThe following tables present reconciliations of our financial results for the fiscal years ended June 30, 2003 and 2002 asreported in conformity with U.S. generally accepted accounting principles (“GAAP”) and those results adjusted to excludecertain charges described above each table. We have presented these reconciliations because of the special nature of thecharges or the fact that they are not necessarily comparable from period to period. We believe that such measuresprovide investors with a view of our ongoing business trends and results of continuing operations. This is consistent withthe approach used by management in its evaluation and monitoring of such trends and results and provides investors witha base for evaluating future periods. There were no events or transactions in fiscal 2004 for which we believe such apresentation would be relevant.

While we consider the non-GAAP financial measures useful in analyzing our results, it is not intended to replace, or actas a substitute for, any presentation included in the consolidated financial statements prepared in conformity with GAAP.

FISCAL 2003The table below reconciles the fiscal 2003 results as reported and results prior to adjustment for a special pre-tax chargeof $22.0 million, or $13.5 million after tax, equal to $.06 per diluted common share, in connection with the proposedsettlement of a class action lawsuit brought against us and a number of other defendants. The amount of the charge in thiscase is significantly larger than similar charges we have incurred individually or in the aggregate for legal proceedings in any prior year and we do not expect to take a charge of a similar magnitude for a single matter like it in the near future.


YEAR ENDED JUNE 30, 2003 Results as Reported Reconciling Items Non-GAAP Results(In millions, except per share data)

Net sales $5,096.0 $ — $5,096.0Cost of sales 1,324.4 — 1,324.4

Gross profit 3,771.6 — 3,771.6

Gross margin 74.0% 74.0%Operating expenses 3,267.9 22.0 3,245.9

Operating expense margin 64.1% 63.7%Operating income 503.7 22.0 525.7

Operating income margin 9.9% 10.3%Provision (benefit) for income taxes 163.3 (8.5) 171.8

Net earnings from continuing operations 325.6 13.5 339.1Discontinued operations, net of tax (5.8) — (5.8)

Net earnings $ 319.8 $13.5 $ 333.3

Net earnings attributable to common stock $ 296.4 $13.5 $ 309.9

Diluted net earnings per common share:Net earnings attributable to common stock

from continuing operations $ 1.29 $ .06 $ 1.35

Net earnings attributable to common stock $ 1.26 $ .06 $ 1.32

FISCAL 2002The table below reconciles the fiscal 2002 results as reported and results prior to adjustment for pre-tax restructuringcharges of $117.4 million (of which $0.8 million was included in discontinued operations), or $76.9 million after tax (of which $0.5 million was included in discontinued operations), equal to $.32 per diluted common share. The restruc-turing charges were related to repositioning certain businesses as part of a globalization and reorganization initiativeand are described in greater detail in Note 5 to Notes to Consolidated Financial Statements. The restructuring was notconsidered part of our core continuing business in fiscal 2002. Management also excludes the related charge in evaluatingits performance when comparing fiscal 2002 to future periods.

YEAR ENDED JUNE 30, 2002 Results as Reported Reconciling Items Non-GAAP Results(In millions, except per share data)

Net sales $4,711.5 $ 6.2 $4,717.7Cost of sales 1,260.5 0.8 1,259.7

Gross profit 3,451.0 7.0 3,458.0

Gross margin 73.2% 73.3%Operating expenses 3,108.9 109.6 2,999.3

Operating expense margin 66.0% 63.6%Operating income 342.1 116.6 458.7

Operating income margin 7.2% 9.7%Provision (benefit) for income taxes 114.7 (40.2) 154.9

Net earnings from continuing operations 212.9 76.4 289.3Discontinued operations, net of tax (21.0) 0.5 (20.5)

Net earnings $ 191.9 $ 76.9 $ 268.8

Net earnings attributable to common stock $ 168.5 $ 76.9 $ 245.4

Diluted net earnings per common share:Net earnings attributable to common stock

from continuing operations $ .79 $ .31 $ 1.10

Net earnings attributable to common stock $ .70 $ .32 $ 1.02

43


FISCAL 2004 AS COMPARED WITH FISCAL 2003

NET SALESNet sales increased 14% or $694.4 million to $5,790.4million, reflecting growth in all product categories and allgeographic regions led by double-digit growth in Europe,the Middle East & Africa and Asia/Pacific and the inclu-sion of a full year of net sales of the Darphin line of prod-ucts, which was acquired during the fourth quarter offiscal 2003. Net sales results in Europe, the Middle East &Africa and Asia/Pacific benefited from the weakening ofthe U.S. dollar. Excluding the impact of foreign currencytranslation, net sales increased 9%.

Product CategoriesSkin Care Net sales of skin care products increased 13%or $246.4 million to $2,140.1 million. This increase wasprimarily attributable to the recent launches of HydraComplete Multi-Level Moisture Cream and IdealistMicro-D Deep Thermal Refinisher by Estée Lauder andPore Minimizer by Clinique. Additionally, the increase wassupported by strong sales of Clinique’s 3-Step Skin CareSystem and the Repairwear line of products from Cliniqueas well as Re-Nutriv Intensive Lift Serum and Re-NutrivIntensive Eye Crème by Estée Lauder. Also contributing tothis increase was the inclusion of a full year of net salesof the Darphin line of products, which are primarily skincare, and growth in developing brands. Partially offsettingthese increases were lower net sales of certain existingproducts such as Advanced Stop Signs by Clinique andWhite Light and Lightsource product lines by EstéeLauder. Excluding the impact of foreign currency transla-tion, skin care net sales increased 8%.

Makeup Makeup net sales increased 14% or $260.5 mil-lion to $2,148.3 million, in part, due to strong sales of ourM.A.C and Bobbi Brown makeup artist lines. The increasein net sales also reflected the current year launches ofIdeal Matte Refinishing Makeup SPF 8 and Electric IntenseLipCreme by Estée Lauder and Perfectly Real Makeup andColour Surge Bare Brilliance by Clinique. Also contribut-ing to net sales growth were strong sales of High ImpactMascara, High Impact Eye Shadow and Skin ClarifyingMakeup by Clinique, as well as Pure Color Lip Vinyl andArtist’s Lip and Eye Pencils from Estée Lauder. Partially off-setting these increases were lower net sales of certainexisting products such as So Ingenious Multi-DimensionLiquid Makeup and Pure Color Lipstick from Estée Lauderand Moisture Surge Lipstick from Clinique. Excluding theimpact of foreign currency translation, makeup net salesincreased 10%.

Fragrance Net sales of fragrance products increased 15%or $161.5 million to $1,221.1 million, primarily attributableto the current year launches of Estée Lauder BeyondParadise, Aramis Life, Clinique Simply and the TommyJeans collection. These product launches primarily con-tributed to increased fragrance net sales outside theUnited States. Additionally, the increase in net sales bene-fited from improved results from our travel retail business.These net sales increases were partially offset by lowernet sales of Estée Lauder pleasures, Intuition and Beautiful,certain Tommy Hilfiger products and Clinique Happy.Excluding the impact of foreign currency translation,fragrance net sales increased 10%.

Hair Care Hair care net sales increased 9% or $20.5 mil-lion to $249.4 million. This increase was primarily theresult of sales growth from Aveda and Bumble and bumbleproducts due to an increase in sales at existing salons andspas, new salon and spa openings and the success of newand existing products. Aveda net sales also increased as aresult of the opening of new Company-owned AvedaExperience Centers. Partially offsetting the increase werelower net sales of Clinique’s Simple Hair Care System.Excluding the impact of foreign currency translation, haircare net sales increased 7%.

The introduction of new products may have some can-nibalizing effect on sales of existing products, which wetake into account in our business planning.

Geographic RegionsNet sales in the Americas increased 7% or $217.0 millionto $3,148.8 million, primarily reflecting growth from ournewer brands, the success of new and recently launchedproducts and increases from most of the Company’sfreestanding retail stores, all of which reflected thestrengthening retail environment. Nevertheless, the pres-tige fragrance business in the United States continues tobe challenging.

In Europe, the Middle East & Africa, net sales increased24% or $363.8 million to $1,870.2 million, primarilyreflecting higher net sales from our travel retail business,the United Kingdom, Spain, Greece and South Africa, aswell as the inclusion of a full year of net sales of theDarphin line of products. We also benefited from the effect of favorable foreign currency exchange rates to the U.S. dollar. Excluding the impact of foreign cur-rency translation, net sales in Europe, the Middle East &Africa increased 14%.

Net sales in Asia/Pacific increased 17% or $113.6million to $771.4 million, primarily due to higher net salesin Japan, Australia, Taiwan, China and Thailand. Excluding

44


the impact of foreign currency translation, net sales inAsia/Pacific increased 9%.

We strategically stagger our new product launches bygeographic market, which may account for differences inregional sales growth.

COST OF SALESCost of sales as a percentage of total net sales improved to25.5% from 26.0% reflecting production and supply chainefficiencies of approximately 70 basis points and lowercosts from promotional activities of approximately 60 basispoints. Partially offsetting these improvements werechanges in exchange rates of approximately 40 basis pointsand costs related to inventory obsolescence and recondi-tioning and re-handling of goods of approximately 20basis points. Also offsetting these improvements were costsassociated with higher travel retail sales, which contri-buted approximately 10 basis points. Travel retail has ahigher cost of goods sold percentage because of its highermix of fragrance sales coupled with its margin structure.

Since certain promotional activities are a componentof sales or cost of sales and the timing and level of pro-motions vary with our promotional calendar, we haveexperienced, and expect to continue to experience, fluc-tuations in the cost of sales percentage. In addition, futurecost of sales mix may be impacted by the inclusion of newbrands which have margin and product cost structuresdifferent than our existing brands.

OPERATING EXPENSESOperating expenses decreased to 63.4% of net sales ascompared with 64.1% of net sales in the prior year. Prior-year operating expenses included a charge related to thepending settlement of a legal proceeding of $22.0 millionor 0.4% of net sales. Before considering the effect of thischarge, operating expenses as a percentage of net salesdecreased 30 basis points from 63.7% in the prior year.Operating expenses as a percentage of net salesdecreased approximately 100 basis points primarily dueto the higher growth rate in net sales, particularly in thetravel retail business, as well as our ongoing cost contain-ment efforts to maintain expenses in line with our busi-ness needs, partially offset by operating expenses relatedto BeautyBank, the higher operating costs associated withnewly acquired brands and expenses related to compli-ance with new regulatory requirements (such as thosearising under the Sarbanes Oxley Act of 2002). Partiallyoffsetting the net favorability in the current year werehigher levels of advertising, merchandising and samplingexpenses incurred to support new and recently launchedproducts of approximately 70 basis points.

Changes in advertising, sampling and merchandisingspending result from the type, timing and level of activi-ties related to product launches and rollouts, as well asthe markets being emphasized.

Under agreements covering our purchase of trade-marks for a percentage of related sales, royalty paymentstotaling $18.8 million and $20.3 million in fiscal 2004 and2003, respectively, have been charged to expense. Suchpayments were made to Mrs. Estée Lauder until her deathon April 24, 2004, after which time the final paymentsceased to accrue and were made to a trust. This eventresulted in a reduction of operating expenses in fiscal2004 of $3.7 million, or $2.2 million after tax. We willrealize a benefit from the elimination of these royaltypayments in fiscal 2005.

OPERATING RESULTSOperating income increased 28% or $140.3 million to$644.0 million. Operating margins were 11.1% of net salesin the current period as compared with 9.9% in the prioryear. Prior year results include a charge related to thepending settlement of a legal proceeding of $22.0 million.Absent this charge, operating income increased 23% or$118.3 million and operating margins increased 80 basispoints from fiscal 2003. These increases in operatingincome and operating margin reflect sales growth,improvements in the components of cost of sales and a reduction in operating expenses as a percentage ofnet sales.

Net earnings and net earnings per diluted shareincreased approximately 7% and 17%, respectively. Netearnings improved $22.3 million to $342.1 million andnet earnings per diluted share increased by 17% from$1.26 to $1.48. Net earnings from continuing operationsincreased by $49.8 million or 15% and diluted earningsper common share from continuing operations increased26% to $1.62 from $1.29 in the prior year. Absent thecharge related to the pending settlement of a legal pro-ceeding, net earnings from continuing operationsincreased by $36.3 million or 11% and diluted earningsper common share from continuing operations increased21% from $1.35.

The following discussions of Operating Results byProduct Categories and Geographic Regions exclude theimpact of the fiscal 2003 charge related to the pendingsettlement of a legal proceeding. We believe the follow-ing analysis of operating income better reflects the man-ner in which we conduct and view our business. The tableon page 43 reconciles these results to operating incomeas reported in the consolidated statements of earnings.

45


Product CategoriesOperating income increased 23% to $336.3 million inskin care, 25% to $257.7 million in makeup and 59% to$23.6 million in hair care reflecting overall sales growthand new product launches. Operating income decreased23% to $24.8 million in fragrance reflecting the softnessin that product category in the United States as well asincreased support spending related to new productlaunch activities.

Geographic RegionsOperating income in the Americas increased 25% or$63.9 million to $319.2 million due to sales growth result-ing from an improved retail environment, strong productlaunches and growth from newer brands. In Europe, theMiddle East & Africa, operating income increased 21% or$46.7 million to $274.4 million primarily due to signifi-cantly improved results from our travel retail business,improved operating results in the United Kingdom andSpain as well as the addition of a full year of results of theDarphin line of products. Partially offsetting theseincreases were lower results in Switzerland and Italy dueto difficult market conditions. In Asia/Pacific, operatingincome increased 18% or $7.7 million to $50.4 million.This increase reflects improved results in Taiwan, HongKong and Thailand, partially offset by lower results in Korea.

INTEREST EXPENSE, NETNet interest expense was $27.1 million as compared with$8.1 million in the prior year. The increase in net interestexpense was due to the inclusion of the dividends onredeemable preferred stock of $17.4 million as interestexpense in fiscal 2004. This change in reporting resultedfrom a change in accounting standards which prohibits usfrom restating the prior fiscal year results (see “RecentlyIssued Accounting Standards”). To a lesser extent, inter-est expense was also affected by higher average net bor-rowings and a marginally higher effective interest rate onour debt portfolio. In fiscal 2005, we expect a reduction ininterest expense as a result of the partial redemption ofpreferred stock and the lower dividend rate on theremaining preferred stock compared to fiscal 2004. See“Liquidity and Capital Resources” for further details.

PROVISION FOR INCOME TAXESThe provision for income taxes represents Federal, for-eign, state and local income taxes. The effective rate forincome taxes for fiscal 2004 was 37.7% as compared with32.9% in the prior year. These rates differ from statutoryrates, reflecting the effect of state and local taxes, tax ratesin foreign jurisdictions and certain nondeductible

expenses. The increase in the effective income tax ratewas attributable to the inclusion of the dividends onredeemable preferred stock as interest expense, whichare not deductible for income tax purposes, the mix ofglobal earnings and, to a lesser extent, the timing of cer-tain tax planning initiatives. The prior year rate includedbenefits derived from certain favorable tax negotiations.

FISCAL 2003 AS COMPARED WITH FISCAL 2002

NET SALESNet sales increased 8% or $384.5 million to $5,096.0 mil-lion, reflecting growth in all product categories and eachof our geographic regions. Product category results wereled by skin care, and our regions were led by Europe, theMiddle East & Africa, where results benefited fromfavorable foreign exchange rates to the U.S. dollar andimprovements in the travel retail business. Travel retailimproved during the middle of fiscal 2003 compared withlower results during the middle of fiscal 2002 but wasadversely affected during the last quarter of fiscal 2003by certain world events, including the lingering effects of the war in Iraq and concerns relating to SARS. Suchevents may affect our future sales and earnings. Excludingthe impact of foreign currency translation, net salesincreased 4%.

Product CategoriesSkin Care Net sales of skin care products increased 11%or $190.4 million to $1,893.7 million, which was primarilyattributable to the recent launches of Perfectionist Cor-recting Serum for Lines/Wrinkles and Resilience LiftOverNight Face and Throat Crème by Estée Lauder, andthe Repairwear line of products and Advanced Stop Signsfrom Clinique. Additionally, the increase was supportedby strong sales of Comforting Cream Cleanser, MoistureSurge Extra Thirsty Skin Relief and Moisture Surge EyeGel, and products in the 3-Step Skin Care System byClinique, as well as by Re-Nutriv Ultimate Lifting Cremefrom Estée Lauder, and A Perfect World line of productsby Origins. Partially offsetting this increase were lower netsales of certain existing products such as Stop Signs, TotalTurnaround Cream and Turnaround Cream by Cliniqueand Idealist Skin Refinisher by Estée Lauder. Excluding theimpact of foreign currency translation, skin care net salesincreased 7%.

Makeup Makeup net sales increased 7% or $129.5million to $1,887.8 million due to strong sales of ourmakeup artist lines and fiscal 2003 launches of DewySmooth Anti-Aging Makeup and Colour Surge Lipstick byClinique, and MagnaScopic Maximum Volume Mascaraand Artist’s Lip and Eye Pencils from Estée Lauder.

46


Also contributing to growth were strong sales from EstéeLauder brand products including So Ingenious Multi-Dimension Liquid Makeup and Loose Powder, as well asfrom new and existing products in the Pure Color line.Offsetting this increase were lower net sales of certainexisting products such as Sumptuous Lipstick from EstéeLauder, and Gentle Light Makeup and Powder and HighImpact Eye Shadow Duos by Clinique. Excluding theimpact of foreign currency translation, makeup net salesincreased 4%.

Fragrance Net sales of fragrance products increased 4%or $42.3 million to $1,059.6 million, primarily reflectingthe effects of favorable foreign currency exchange rates tothe U.S. dollar. The fragrance industry continues to expe-rience a difficult environment. The travel retail business,which depends substantially on fragrance products, beganto improve in the middle of the fiscal year relative to theprior year, however the latter part of fiscal 2003 wasadversely affected by international uncertainties stem-ming from events in Iraq and concerns relating to SARS.In fiscal 2003, we successfully launched Estée Lauderpleasures intense, T girl by Tommy Hilfiger, Clinique HappyHeart, Lauder Intuition for Men and Donna Karan BlackCashmere. Net sales also benefited from strong sales ofBeautiful by Estée Lauder and Aromatics Elixir fromClinique. Offsetting these increases and sales from newproduct launches were lower net sales of certain TommyHilfiger products, Intuition by Estée Lauder and EstéeLauder pleasures. Excluding the impact of foreigncurrency translation, fragrance net sales were relativelyunchanged from the prior year.

Hair Care Hair care net sales increased 6% or $13.1 mil-lion to $228.9 million. This increase was primarily theresult of sales growth from Aveda and Bumble andbumble products. We also increased the number ofCompany-owned Aveda Experience Centers and strate-gically decreased the number of salons that offer Avedaproducts. Partially offsetting the increase were lower netsales of Clinique’s Simple Hair Care System.

The introduction of new products may have some can-nibalizing effect on sales of existing products, which wetake into account in our business planning.

Geographic RegionsNet sales in the Americas increased 3% or $85.8 million to$2,931.8 million primarily reflecting growth from our newerbrands as well as the success of newly launched products.Despite the increase, we continued to experience a softretail environment in the United States in fiscal 2003.

In Europe, the Middle East & Africa, net sales increased19% or $245.3 million to $1,506.4 million. Net sales inthe United Kingdom, Spain, Italy, France, Switzerland andGreece experienced double-digit growth. Also contribut-ing to the increase with double-digit growth was ourworldwide travel retail business, as sales recovered fromthe levels experienced after September 11, 2001. How-ever, our travel retail business was adversely affected atthe end of fiscal 2003 by certain world events includingthe lingering effects of the war in Iraq and concernsassociated with SARS. Excluding the impact of foreigncurrency translation, Europe, the Middle East & Africa netsales increased 8%.

Net sales in Asia/Pacific increased 8% or $47.2 millionto $657.8 million primarily due to higher net sales inKorea, Japan, Australia and Thailand. Despite increasednet sales in Japan, the country remained a difficult mar-ket due to local economic conditions and competition.Excluding the impact of foreign currency translation,Asia/Pacific net sales increased 3%.

We strategically stagger our new product launches bygeographic market, which may account for differences inregional sales growth.

COST OF SALESCost of sales as a percentage of total net sales improved to26.0% from 26.8%, reflecting production and supply chainefficiencies and lower costs from promotional activities.

We continued to emphasize sourcing initiatives andoverall supply chain management which resulted in lowermanufacturing costs, whereas in the prior year we experi-enced under-absorption of overhead as a result of theimpact of the events of September 11, 2001.

The inclusion of promotional merchandise as a com-ponent of cost of sales results in lower margins. A strategicshift to reduce these activities in fiscal 2003 contributedto the improvement in our gross profit margin for the year.The inclusion of the cost of purchase with purchase andgift with purchase merchandise as a component of cost ofsales resulted from our adoption of EITF Issue No. 01-9.Since the cost of these promotional activities is a compo-nent of cost of sales and the timing and level of promo-tions vary with our promotional calendar, we experienced,and expect to continue to experience, fluctuations in thecost of sales percentage.

OPERATING EXPENSESOperating expenses decreased to 64.1% of net sales ascompared with 66.0% of net sales in the prior-yearperiod. The fiscal 2003 results were impacted by a chargerelated to the pending settlement of a legal proceeding of

47


$22.0 million or 0.4% of net sales. Fiscal 2002 operatingexpenses included a restructuring charge of $109.6 mil-lion or 2.3% of net sales. Before considering the effect ofthese two charges, operating expenses increased slightlyto 63.7% of net sales compared with 63.6% of net sales inthe prior year. The increase in spending primarily relatedto advertising, sampling and merchandising activities par-ticularly during the early portion of fiscal 2003 (excludingpurchase with purchase and gift with purchase activities,discussed as a component of cost of sales) whichsupported our sales growth and built momentum goinginto the second half of fiscal 2003. Changes in advertising,sampling and merchandising spending result from thetype, timing and level of activities related to productlaunches and rollouts, as well as the markets beingemphasized.

OPERATING RESULTSOperating income increased 47% or $161.6 million to$503.7 million as compared with the prior-year period.Operating margins were 9.9% of net sales in fiscal 2003 ascompared with 7.2% in fiscal 2002. These results includea charge related to the pending settlement of a legal pro-ceeding of $22.0 million in the current year and a prioryear restructuring charge of $116.6 million. Absent theseitems, operating income increased 15% or $67.0 million to$525.7 million and operating margins increased to 10.3%as compared with 9.7% in fiscal 2002. These increases inoperating income and operating margin reflect salesgrowth, including the benefits from favorable foreign cur-rency exchange rates to the U.S. dollar and gross marginimprovement, as well as benefits from our prior restruc-turings and our continued cost containment efforts.

Net earnings and net earnings per diluted shareincreased approximately 67% and 80%, respectively. Netearnings improved $127.9 million to $319.8 million andnet earnings per diluted share increased by $.56 from$.70 to $1.26. Net earnings from continuing operationsincreased by $112.7 million or 53% and diluted earningsper common share from continuing operations increased63% to $1.29 from $.79 in the prior year. Before the fiscal2003 charge related to the pending settlement of a legalproceeding and the fiscal 2002 restructuring, net earn-ings from continuing operations increased 17% to $339.1million and diluted earnings per common share fromcontinuing operations increased 23% to $1.35 from $1.10in the prior year.

The following discussions of Operating Results byProduct Categories and Geographic Regions exclude theimpact of the fiscal 2003 charge related to the pendingsettlement of a legal proceeding and the fiscal 2002

restructuring. We believe the following analysis ofoperating income better reflects the manner in which weconduct and view our business. The tables on page 43reconcile these results to operating income as reportedin the consolidated statements of earnings.

Product CategoriesOperating income more than doubled to $32.1 million infragrance due primarily to improved results from ourtravel retail business. Operating income increased 10% to$273.2 million in skin care and 13% to $206.6 million inmakeup reflecting higher net sales, partially offset bystrategic spending on advertising, sampling and mer-chandising, particularly in the earlier portion of fiscal2003. Operating income increased $1.1 million or 8% to$14.8 million in hair care, reflecting improvements inAveda and Bumble and bumble, as well as higher profits inthe latter portion of the year outside the United States.

Geographic RegionsOperating income in the Americas increased 15% or$32.5 million to $255.3 million due to sales growth, thebenefits of our prior restructurings and continued costcontainment efforts. Operating income also benefitedfrom the results of strategic efforts related to product sup-port spending in the earlier part of the year that led toincreased net sales during the year. In Europe, the MiddleEast & Africa, operating income increased 27% or $47.8million to $227.7 million primarily due to the improvedoperating results in the United Kingdom as well asincreased results generated from our travel retail business.As described elsewhere, profitability in the region hasbeen and will continue to be affected by internationaluncertainties. In Asia/Pacific, operating income decreased24% or $13.3 million to $42.7 million. This decreasereflects improved results in Korea and Thailand, whichwere more than offset by a decrease in Australia, whichderived a benefit in the prior-year period from a change inour retailer arrangements.

INTEREST EXPENSE, NETNet interest expense was $8.1 million as compared with$9.8 million in fiscal 2002. The decrease in net interestexpense was primarily due to lower outstanding net bor-rowings and higher interest income generated by higherinvested cash balances. This improvement was partiallyoffset by a higher effective interest rate, which resultedfrom the increased proportion of fixed rate debt as com-pared with variable rate debt in the prior year. In May2003, we executed a fixed-to-floating interest rate swapon our $250.0 million 6% Senior Notes due 2012. See“Liquidity and Capital Resources” for further details.

48


PROVISION FOR INCOME TAXESThe provision for income taxes represents Federal, for-eign, state and local income taxes. The effective rate forincome taxes for fiscal 2003 was 32.9% as compared with34.5% in fiscal 2002. These rates differ from statutoryrates, reflecting the effect of state and local taxes, tax ratesin foreign jurisdictions and certain nondeductibleexpenses. The decrease in the effective tax rate was prin-cipally attributable to ongoing tax planning initiatives,including the favorable settlement of certain tax negotia-tions and the reduction of the overall tax rate relating tothe Company’s foreign operations. In addition, the taxeffect of the charge related to the pending settlement of alegal proceeding in late fiscal 2003 contributed to aneffective tax rate slightly lower than previously expected.

FINANCIAL CONDITION

LIQUIDITY AND CAPITAL RESOURCESOur principal sources of funds historically have been cashflows from operations and borrowings under commercialpaper, borrowings from the issuance of long-term debtand committed and uncommitted credit lines providedby banks in the United States and abroad. At June 30,2004, we had cash and cash equivalents of $611.6 mil-lion compared with $364.1 million at June 30, 2003.

At June 30, 2004, our outstanding borrowings of$535.3 million included: (i) $236.6 million of 6% SeniorNotes due January 2012 consisting of $250.0 million prin-cipal, unamortized debt discount of $0.9 million and a$12.5 million adjustment to reflect the fair value of anoutstanding interest rate swap; (ii) $197.3 million of5.75% Senior Notes due October 2033 consisting of$200.0 million principal and unamortized debt discountof $2.7 million; (iii) $68.4 million of CumulativeRedeemable Preferred Stock, which shares have a manda-tory redemption date of June 30, 2015 (see “RecentlyIssued Accounting Standards”); (iv) a 3.0 billion yen termloan (approximately $27.6 million at exchange rates as ofJune 30, 2004), which is due in March 2006; and (v) $5.4million of other short-term borrowings.

In September 2003, we issued and sold $200.0 millionof 5.75% Senior Notes due October 2033 (“5.75% SeniorNotes”) in a public offering. The 5.75% Senior Notes werepriced at 98.645% with a yield of 5.846%. Interest pay-ments, which commenced April 15, 2004, will be madesemi-annually on April 15 and October 15 of each year. InMay 2003, in anticipation of the issuance of the 5.75%Senior Notes, we entered into a series of treasury lockagreements on a notional amount totaling $195.0 millionat a weighted average all-in rate of 4.53%. The treasury

lock agreements were settled upon the issuance of thenew debt and we received a payment of $15.0 millionthat will be amortized against interest expense over thelife of the 5.75% Senior Notes. As a result of the treasurylock agreements, the debt discount and debt issuancecosts, our effective interest rate on the 5.75% SeniorNotes will be 5.395% over the life of the debt. We issuedthese fixed-rate notes to lock in long-term liquidity athistorically low prevailing market rates and to mitigatefuture interest rate volatility.

On December 31, 2003, we and the holders of the$6.50 Cumulative Redeemable Preferred Stock exchangedall of the outstanding shares of $6.50 CumulativeRedeemable Preferred Stock due June 30, 2005 for anewly issued series of cumulative redeemable preferredstock with a mandatory redemption date of June 30,2015 (“2015 Preferred Stock”). For the quarters endedDecember 31, 2003 and March 31, 2004, the dividendrate on the 2015 Preferred Stock was 4.75% per annum,payable quarterly.

On April 24, 2004, Mrs. Estée Lauder passed away. As aresult, our right to call for redemption $291.6 million ofthe 2015 Preferred Stock became exercisable and theholders’ right to put to us all $360.0 million aggregateprincipal amount of the 2015 Preferred Stock becameexercisable.

On June 10, 2004, we redeemed, for cash, all $291.6million aggregate principal amount of 2015 PreferredStock that could be redeemed at that time. Upon this par-tial redemption, the dividend rate on the remaining $68.4million principal amount of 2015 Preferred Stock wasreduced, for the period from April 25, 2004 through June30, 2004, from 4.75% per annum to 0.62% per annum,which is a rate based on the after-tax yield on six-monthU.S. Treasuries. So long as the remaining shares of 2015Preferred Stock are outstanding, the dividend rate will bereset semi-annually in January and July at the then-existing after-tax yield on six-month U.S. Treasuries. Thedividend rate for the six-month period from July 1, 2004through December 31, 2004 is 0.994%. As a result of theredemption of the $291.6 million principal amount of2015 Preferred Stock and the reduction of the dividendrate on the remaining $68.4 million principal amount of2015 Preferred Stock, we expect to save, net of financingcosts, approximately $14.0 million in fiscal 2005.

The remaining $68.4 million principal amount of 2015Preferred Stock may be put to us at any time at face value,but may not be redeemed by us until May 24, 2005. If putto us on or before June 30, 2005, we would have up to120 days after the exercise date of the put to pay for theshares. If the remaining shares of 2015 Preferred Stock

49


are put to us or if we call those shares for redemption, weexpect to use cash on hand to fund the redemption.

We have a $750.0 million commercial paper programunder which we may issue commercial paper in theUnited States. Our commercial paper is currently rated A-1by Standard & Poor’s and P-1 by Moody’s. Our long-termcredit ratings are A+ with a negative outlook by Standard& Poor’s and A1 with a stable outlook by Moody’s. At June30, 2004, we had no commercial paper outstanding. Wealso have an effective shelf registration statement cover-ing the potential issuance of up to an additional $300.0million in debt securities. As of June 30, 2004, we had anunused $400.0 million revolving credit facility, expiringon June 28, 2006, and $173.3 million in additional uncom-mitted credit facilities, of which $5.4 million was used.

Our business is seasonal in nature and, accordingly, ourworking capital needs vary. From time to time, we mayenter into investing and financing transactions that requireadditional funding. To the extent that these needs exceedcash from operations, we could, subject to market condi-tions, issue commercial paper, issue long-term debt secu-rities or borrow under the revolving credit facility.

Total debt as a percent of total capitalization was 24%at June 30, 2004 as compared with 14% at June 30, 2003.This increase primarily reflects the classification of the2015 Preferred Stock as short-term debt as well as theissuance of the 5.75% Senior Notes in fiscal 2004.

The effects of inflation have not been significant to ouroverall operating results in recent years. Generally, wehave been able to introduce new products at higher sell-ing prices or increase selling prices sufficiently to offsetcost increases, which have been moderate.

We believe that cash on hand, cash generated fromoperations, available credit lines and access to creditmarkets will be adequate to support currently plannedbusiness operations and capital expenditures on both anear-term and long-term basis.

Cash FlowsNet cash provided by operating activities was $669.8million in fiscal 2004 as compared with $553.1 million infiscal 2003 and $519.3 million in fiscal 2002. Theimproved operating cash flow primarily reflects increasednet earnings from continuing operations and an increasein accrued costs. Changes in operating assets and liabili-ties reflect partially offsetting increases in accountspayable and inventory in anticipation of product launchesin fiscal 2005, higher accounts receivable in line with salesgrowth, and changes in other assets and accrued liabilitiesthat reflect receipts and accruals from employee

compensation and benefit related transactions as well asselling, advertising and merchandising activities. Weexpect cash flows from operations in fiscal 2005 to reflectpayments of approximately $47 million, net of tax, relatedto deferred compensation and supplemental pensionarrangements. The improvement in net cash flows for fis-cal 2003 compared to fiscal 2002 reflected increasedearnings and seasonal levels of operating assets and lia-bilities. Operating assets and liabilities reflected animprovement in accounts receivable collections in fiscal2003, and a higher level of accounts payable, partially off-set by increased inventories at June 30, 2003 in anticipa-tion of product launches in the first half of fiscal 2004 andthe impact of acquisitions on required inventory levels.

Net cash used for investing activities was $208.0 mil-lion in fiscal 2004, compared with $192.5 million in fiscal2003 and $217.0 million in fiscal 2002. Net cash used ininvesting activities in fiscal 2004 primarily related to capi-tal expenditures. Net cash used in investing activitiesduring fiscal 2003 primarily related to capital expendituresand the acquisition of Darphin and certain Aveda distrib-utors. Net cash used in fiscal 2002 related primarily tocapital expenditures.

Capital expenditures amounted to $206.5 million,$163.1 million and $203.2 million in fiscal 2004, 2003 and2002, respectively. Spending in all three years primarilyreflected the continued upgrade of manufacturing equip-ment, dies and molds, new store openings, store improve-ments, counter construction and information technologyenhancements. In fiscal 2005, we expect our capitalexpenditures to increase as a result of a company-wideinitiative to upgrade our financial systems as well as ourplan to invest in leasehold improvements in our corporateoffices. The reduced level of capital expenditures in fiscal2003 reflected tight control on our spending in light ofthen-prevailing economic conditions, fewer retail storeopenings and reduced spending related to leaseholdimprovements.

Cash used for financing activities was $216.0 million,$555.0 million and $123.1 million in fiscal 2004, 2003 and2002, respectively. The net cash used for financing activi-ties in fiscal 2004 primarily related to the redemption of$291.6 million aggregate principal amount of the 2015Preferred Stock, common stock repurchases and dividendpayments partially offset by proceeds from the issuance ofthe 5.75% Senior Notes and employee stock transactions.Net cash used for financing during fiscal 2003 and fiscal2002 primarily related to common stock repurchases, therepayment of long-term debt and dividend payments.

50


DividendsOn November 5, 2003, the Board of Directors declaredan annual dividend of $.30 per share on our Class A andClass B Common Stock, payable on January 6, 2004 tostockholders of record at the close of business on Decem-ber 16, 2003. Common stock dividends paid during thefiscal years 2004, 2003 and 2002 were $68.5 million,$58.3 million and $47.6 million, respectively. Dividendspaid on the preferred stock were $17.4 million for theyear ended June 30, 2004 and $23.4 million for the yearsended June 30, 2003 and 2002. The decrease reflects anagreement to reduce the dividend of the preferred stockmade in connection with the exchange of the preferredshares on December 31, 2003 and the redemption of $291.6 million aggregate principal amount of 2015Preferred Stock on June 10, 2004. The dividend rate onthe remaining $68.4 million principal amount of 2015Preferred Stock was reduced, for the period from April25, 2004 through June 30, 2004, from 4.75% per annumto 0.62% per annum, which is a rate based on the after-tax yield on six-month U.S. Treasuries. The dividend ratefor the six-month period July 1, 2004 through December31, 2004 is 0.994%. So long as the remaining shares of2015 Preferred Stock are outstanding, the dividend ratewill be reset semi-annually in January and July at the then existing after-tax yield on six-month U.S. Treasuries.The cumulative redeemable preferred stock dividendsdeclared for the year ended June 30, 2004 have beencharacterized as interest expense (see “Recently IssuedAccounting Standards”).

Pension Plan Funding and ExpenseWe maintain pension plans covering substantially all ofour full-time employees for our U.S. operations and amajority of our international operations. Several plans pro-vide pension benefits based primarily on years of serviceand employees’ earnings. In the United States, we main-tain a trust-based, noncontributory defined benefit pen-sion plan (“U.S. Plan”). Additionally, we have an unfunded,nonqualified domestic noncontributory pension plan toprovide benefits in excess of statutory limitations. Ourinternational pension plans are comprised of definedbenefit and defined contribution plans.

Several factors influence our annual funding require-ments. For the U.S. Plan, our funding policy consists ofannual contributions at a rate that provides for future planbenefits and maintains appropriate funded percentages.Such contribution is not less than the minimum requiredby the Employee Retirement Income Security Act of1974, as amended (“ERISA”), and subsequent pension

legislation and is not more than the maximum amountdeductible for income tax purposes. For each internationalplan, our funding policies are determined by local lawsand regulations. In addition, amounts necessary to fundfuture obligations under these plans could vary dependingon estimated assumptions (as detailed in “CriticalAccounting Polices and Estimates”). The effect on operat-ing results in the future of pension plan funding willdepend on economic conditions, employee demograph-ics, mortality rates, the number of participants electing totake lump-sum distributions, investment performance andfunding decisions.

For fiscal 2004 and 2003 there was no minimum con-tribution to the U.S. Plan required by ERISA. However, atmanagement’s discretion, we made cash contributions tothe U.S. Plan of $33.0 million and $76.0 million during fis-cal 2004 and 2003, respectively. Depending upon mar-ket conditions during fiscal 2005, we expect to make cashcontributions to our U.S. Plan of $16.0 million.

In addition, at June 30, 2004 and 2003, we recognizeda liability on our balance sheet for each pension plan ifthe fair market value of the assets of that plan was lessthan the accumulated benefit obligation and, accordingly,a benefit or a charge was recorded in accumulated othercomprehensive income (loss) in shareholders’ equity.During fiscal 2004, we recorded a benefit, net of deferredtax, of $16.0 million, while in fiscal 2003, we recorded acharge, net of deferred tax, of $20.3 million to accumu-lated other comprehensive income (loss).

Commitments and ContingenciesOn June 10, 2004, we redeemed all $291.6 millionaggregate principal amount of 2015 Preferred Stock thatcould be redeemed at that time. The remaining $68.4 mil-lion principal amount of 2015 Preferred Stock may be putto us at any time at face value, but may not be redeemedby us until May 24, 2005. If shares of the 2015 PreferredStock are put to us on or before June 30, 2005, we wouldhave up to 120 days after notice to purchase such shares.

Certain of our business acquisition agreements include“earn-out” provisions. These provisions generally requirethat we pay to the seller or sellers of the business addi-tional amounts based on the performance of the acquiredbusiness. The payments typically are made after a certainperiod of time and our next “earn-out” payment isexpected to be made after the end of fiscal 2005. Sincethe size of each payment depends upon performance ofthe acquired business, we do not expect that such pay-ments will have a material adverse impact on our futureresults of operations or financial condition.

51


Derivative Financial Instruments and Hedging ActivitiesWe address certain financial exposures through a con-trolled program of risk management that includes the useof derivative financial instruments. We primarily enter intoforeign currency forward exchange contracts and foreigncurrency options to reduce the effects of fluctuating for-eign currency exchange rates. We also enter into interestrate derivative contracts to manage the effects of fluctu-ating interest rates. We categorize these instruments asentered into for purposes other than trading.

For each derivative contract entered into where we lookto obtain special hedge accounting treatment, we for-mally document the relationship between the hedginginstrument and hedged item, as well as its risk-manage-ment objective and strategy for undertaking the hedge.This process includes linking all derivatives that are desig-nated as fair-value, cash-flow, or foreign-currency hedgesto specific assets and liabilities on the balance sheet or tospecific firm commitments or forecasted transactions. Wealso formally assess, both at the hedge’s inception and onan ongoing basis, whether the derivatives that are used inhedging transactions are highly effective in offsettingchanges in fair values or cash flows of hedged items. If it isdetermined that a derivative is not highly effective, thenwe will be required to discontinue hedge accounting withrespect to that derivative prospectively.

Foreign Exchange Risk ManagementWe enter into forward exchange contracts to hedge antici-pated transactions as well as receivables and payables

denominated in foreign currencies for periods consistentwith our identified exposures. The purpose of the hedgingactivities is to minimize the effect of foreign exchangerate movements on our costs and on the cash flows thatwe receive from foreign subsidiaries. Almost all foreigncurrency contracts are denominated in currencies ofmajor industrial countries and are with large financial insti-tutions rated as strong investment grade by a major ratingagency. We also enter into foreign currency options tohedge anticipated transactions where there is a high prob-ability that anticipated exposures will materialize. The for-ward exchange contracts and foreign currency optionsentered into to hedge anticipated transactions have been designated as cash-flow hedges. As of June 30,2004, these cash-flow hedges were highly effective, in allmaterial respects.

As a matter of policy, we only enter into contracts withcounterparties that have at least an “A” (or equivalent)credit rating. The counterparties to these contracts aremajor financial institutions. We do not have significantexposure to any one counterparty. Our exposure to creditloss in the event of nonperformance by any of the coun-terparties is limited to only the recognized, but not real-ized, gains attributable to the contracts. Managementbelieves risk of default under these hedging contracts isremote and in any event would not be material to the con-solidated financial results. The contracts have varyingmaturities through the end of June 2005. Costs associ-ated with entering into such contracts have not beenmaterial to our consolidated financial results. We do not

52

Contractual ObligationsThe following table summarizes scheduled maturities of our contractual obligations for which cash flows are fixed anddeterminable as of June 30, 2004.

Total 2005 2006 2007 2008 2009 Thereafter(In millions)

Long-term debt including current portion(1) $ 535.3 $ 73.8 $ 27.6 $ — $ — $ — $ 433.9Lease commitments(2) 1,001.9 132.8 122.5 108.9 92.6 80.9 464.2Unconditional purchase obligations(3) 873.7 372.8 115.0 77.4 76.4 42.7 189.4Deferred compensation(4) 16.1 16.1 — — — — —

Total contractual obligations $2,427.0 $595.5 $265.1 $186.3 $169.0 $123.6 $1,087.5

(1) Refer to Notes 8 and 12 of Notes to Consolidated Financial Statements.

(2) Includes operating lease commitments, and to a lesser extent, minimal capital lease commitments. Refer to Note 15 of Notes to Consolidated Financial Statements.

(3) Unconditional purchase obligations primarily include inventory commitments, estimated future earn-out payments, estimated royalty payments pursuantto license agreements, advertising commitments and capital improvement commitments.

(4) Share units that were recorded as a component of Stockholders’ Equity as of June 30, 2004 have been converted to the cash equivalent value andplaced in a deferred compensation account in fiscal 2005 based on a decision of the Compensation Committee of the Board of Directors in August 2004.

Payments Due in Fiscal


utilize derivative financial instruments for trading or spec-ulative purposes. At June 30, 2004, we had foreign cur-rency contracts in the form of forward exchange contractsand option contracts in the amount of $593.6 million and $82.0 million, respectively. The foreign currenciesincluded in forward exchange contracts (notional valuestated in U.S. dollars) are principally the Euro ($122.6 mil-lion), Swiss franc ($117.1 million), British pound ($72.8million), Japanese yen ($66.7 million), South Korean won($42.0 million), Canadian dollar ($41.7 million), andAustralian dollar ($33.7 million). The foreign currenciesincluded in the option contracts (notional value stated inU.S. dollars) are principally the Euro ($34.1 million), Britishpound ($25.4 million), and Swiss franc ($12.7 million).

Interest Rate Risk ManagementWe enter into interest rate derivative contracts to managethe exposure to fluctuations of interest rates on ourfunded and unfunded indebtedness, as well as cash invest-ments, for periods consistent with the identified expo-sures. All interest rate derivative contracts are with largefinancial institutions rated as strong investment grade by amajor rating agency.

We have an interest rate swap agreement with anotional amount of $250.0 million to effectively convertfixed interest on the existing $250.0 million 6% SeniorNotes to variable interest rates based on six-month LIBOR.We designated the swap as a fair value hedge. As of June30, 2004, the fair value hedge was highly effective, in allmaterial respects.

Additionally, in May 2003, in connection with the antic-ipated issuance of debt, we entered into a series of treas-ury lock agreements on a notional amount totaling$195.0 million at a weighted average all-in rate of 4.53%.These treasury lock agreements were used to hedge theexposure to a possible rise in interest rates prior to theSeptember 2003 issuance of debt. The agreements weresettled upon the issuance of the $200.0 million of 5.75%Senior Notes and we realized a gain in other comprehen-sive income of $15.0 million that is currently being amor-tized against interest expense over the 30-year life of the5.75% Senior Notes.

Market RiskWe use a value-at-risk model to assess the market risk ofour derivative financial instruments. Value-at-risk repre-sents the potential losses for an instrument or portfoliofrom adverse changes in market factors for a specifiedtime period and confidence level. We estimate value-at-risk across all of our derivative financial instruments usinga model with historical volatilities and correlationscalculated over the past 250-day period. The measured

value-at-risk, calculated as an average, for the twelvemonths ended June 30, 2004 related to our foreignexchange contracts and our interest rate contracts was$9.5 million and $14.5 million, respectively. The modelestimates were made assuming normal market conditionsand a 95 percent confidence level. We used a statisticalsimulation model that valued our derivative financialinstruments against one thousand randomly generatedmarket price paths.

Our calculated value-at-risk exposure represents anestimate of reasonably possible net losses that would berecognized on our portfolio of derivative financial instru-ments assuming hypothetical movements in future mar-ket rates and is not necessarily indicative of actual results,which may or may not occur. It does not represent themaximum possible loss or any expected loss that mayoccur, since actual future gains and losses will differ fromthose estimated, based upon actual fluctuations in mar-ket rates, operating exposures, and the timing thereof, andchanges in our portfolio of derivative financial instrumentsduring the year.

We believe, however, that any loss incurred would beoffset by the effects of market rate movements on therespective underlying transactions for which the hedge is intended.

OFF-BALANCE SHEET ARRANGEMENTSWe do not maintain any off-balance sheet arrangements,transactions, obligations or other relationships with uncon-solidated entities that would be expected to have a mate-rial current or future effect upon our financial condition orresults of operations.

RECENTLY ISSUED ACCOUNTING STANDARDSOn May 19, 2004, the Financial Accounting StandardsBoard (“FASB”) issued FASB Staff Position No. FAS 106-2,“Accounting and Disclosure Requirements Related to theMedicare Prescription Drug, Improvement and Modern-ization Act of 2003” (“FSP No. 106-2”), in response to anew law regarding prescription drug benefits underMedicare (“Medicare Part D”) and a Federal subsidy tosponsors of retiree health care benefit plans that providea benefit that is at least actuarially equivalent to MedicarePart D. Currently, Statement of Financial Accounting Stan-dard No. 106, “Employers’ Accounting for PostretirementBenefits Other Than Pensions” (“SFAS No. 106”), requiresthat changes in relevant law be considered in currentmeasurement of postretirement benefit costs. FSP No. 106-2 will be effective for financial statements ofcompanies for the first interim or annual period beginningafter June 15, 2004. We will adopt FSP No. 106-2 in the

53


first quarter of fiscal 2005 and will recognize the impactof the new law under Medicare Part D, which will not bematerial to our results of operations, cash flows, or finan-cial condition. Therefore, any measures of the accumu-lated postretirement benefit obligation or the net periodicpostretirement benefit cost as of and for the year endedJune 30, 2004 do not reflect the effects of the new law.

In December 2003, the FASB issued FASB Interpre-tation Number 46-R (“FIN 46-R”), “Consolidation ofVariable Interest Entities.” FIN 46-R, which modifies certainprovisions and effective dates of FIN 46, sets forth criteriato be used in determining whether an investment in a vari-able interest entity should be consolidated. These provi-sions are based on the general premise that if a companycontrols another entity through interests other than vot-ing interests, that company should consolidate the con-trolled entity. We have evaluated whether the provisionsof FIN 46-R are applicable to our investments, certain ofwhich are currently accounted for by the equity method,as well as other arrangements, which may meet the criteriaof the interpretation, and believe that there are currentlyno material arrangements that meet the definition of avariable interest entity which would require consolidation.

In December 2003, the FASB revised Statement ofFinancial Accounting Standard No. 132 (Revised 2003),“Employers’ Disclosures about Pensions and other Postre-tirement Benefits” (“SFAS No. 132 (R)”), establishing addi-tional annual disclosures about plan assets, investmentstrategy, measurement date, plan obligations and cashflows. In addition, the revised standard established interimdisclosure requirements related to the net periodic bene-fit cost recognized and contributions paid or expected tobe paid during the current fiscal year. The new annual dis-closures are effective for financial statements of compa-nies with fiscal years ending after December 15, 2003 andthe interim-period disclosures are effective for interimperiods beginning after December 15, 2003. We adoptedthe interim disclosures for our fiscal quarter ended March31, 2004 and the annual disclosures for our fiscal yearending June 30, 2004. The adoption of the revised SFASNo. 132 (R) had no impact on our results of operations orfinancial condition.

We have adopted Statement of Financial AccountingStandard No. 150, “Accounting for Certain FinancialInstruments with Characteristics of both Liabilities andEquity” (“SFAS No. 150”). SFAS No. 150 established stan-dards for classifying and measuring certain financialinstruments with characteristics of both liabilities andequity. Among other things, it specifically requires thatmandatorily redeemable instruments, such as redeemable

preferred stock, be classified as a liability. Initial and sub-sequent measurements of the instruments differ based onthe characteristics of each instrument and as provided forin the statement. Based on the provisions of this state-ment, we have classified the cumulative redeemable pre-ferred stock as a liability and the related dividendsthereon have been characterized as interest expense.Restatement of financial statements for earlier yearspresented was not permitted. The adoption of thisstatement has resulted in the inclusion of the dividendson the preferred stock (equal to $17.4 million for the year ended June 30, 2004) as interest expense. While the inclusion has impacted net earnings, net earningsattributable to common stock and earnings per commonshare were unaffected. Given that the dividends are notdeductible for income tax purposes, the inclusion of thepreferred stock dividends as an interest expense hascaused an increase in our effective tax rate for fiscal 2004.The adoption of SFAS No. 150 had no impact on ourfinancial condition.

FORWARD-LOOKING INFORMATIONWe and our representatives from time to time make writ-ten or oral forward-looking statements, including state-ments contained in this and other filings with theSecurities and Exchange Commission, in our pressreleases and in our reports to stockholders. The words andphrases “will likely result,” “expect,” “believe,” “planned,”“will,” “will continue,” “may,” “could,” “anticipated,”“estimate,” “project” or similar expressions are intendedto identify “forward-looking statements” within the mean-ing of the Private Securities Litigation Reform Act of 1995.These statements include, without limitation, our expec-tations regarding sales, earnings or other future financialperformance and liquidity, product introductions, entryinto new geographic regions, information systems initia-tives, new methods of sale and future operations or oper-ating results. Although we believe that our expectationsare based on reasonable assumptions within the boundsof our knowledge of our business and operations, actualresults may differ materially from our expectations. Factorsthat could cause actual results to differ from expectationsinclude, without limitation:

(1) increased competitive activity from companies in theskin care, makeup, fragrance and hair care businesses,some of which have greater resources than we do;

(2) our ability to develop, produce and market newproducts on which future operating results may depend;

54


(3) consolidations, restructurings, bankruptcies andreorganizations in the retail industry causing a decrease inthe number of stores that sell our products, an increasein the ownership concentration within the retail industry,ownership of retailers by our competitors and ownershipof competitors by our customers that are retailers;

(4) shifts in the preferences of consumers as to where andhow they shop for the types of products and services we sell;

(5) social, political and economic risks to our foreign ordomestic manufacturing, distribution and retail opera-tions, including changes in foreign investment and tradepolicies and regulations of the host countries and of theUnited States;

(6) changes in the laws, regulations and policies thataffect, or will affect, our business, including changes inaccounting standards, tax laws and regulations, trade rulesand customs regulations, and the outcome and expenseof legal or regulatory proceedings;

(7) foreign currency fluctuations affecting our results ofoperations and the value of our foreign assets, the rela-tive prices at which we and our foreign competitors sellproducts in the same markets and our operating andmanufacturing costs outside of the United States;

(8) changes in global or local economic conditions thatcould affect consumer purchasing, the willingness of con-sumers to travel, the financial strength of our customers,the cost and availability of capital, which we may need fornew equipment, facilities or acquisitions, and the assump-tions underlying our critical accounting estimates;

(9) shipment delays, depletion of inventory and increasedproduction costs resulting from disruptions of operationsat any of the facilities which, due to consolidations in our manufacturing operations, now manufacture nearly all of our supply of a particular type of product (i.e., focus factories);

(10) real estate rates and availability, which may affect ourability to increase the number of retail locations at whichwe sell our products and the costs associated with ourother facilities;

(11) changes in product mix to products which are less profitable;

(12) our ability to acquire or develop new information anddistribution technologies, on a timely basis and within ourcost estimates;

(13) our ability to capitalize on opportunities for improvedefficiency, such as globalization, and to integrate acquiredbusinesses and realize value therefrom; and

(14) consequences attributable to the events that arecurrently taking place in the Middle East, including further attacks, retaliation and the threat of further attacksor retaliation.

We assume no responsibility to update forward-lookingstatements made herein or otherwise.

55


CONSOLIDAT ED BAL ANCE SHEE TS

JUNE 30 2004 2003(In millions, except share data)

ASSETSCurrent AssetsCash and cash equivalents $ 611.6 $ 364.1Accounts receivable, net 664.9 634.2Inventory and promotional merchandise, net 653.5 599.0Prepaid expenses and other current assets 269.2 247.6

Total current assets 2,199.2 1,844.9

Property, Plant and Equipment, net 647.0 607.7

Other AssetsInvestments, at cost or market value 12.6 14.0Goodwill, net 672.3 695.3Other intangible assets, net 71.9 65.4Other assets, net 105.1 122.6

Total other assets 861.9 897.3

Total assets $3,708.1 $3,349.9

LIABILITIES AND STOCKHOLDERS’ EQUITYCurrent LiabilitiesShort-term debt $ 73.8 $ 7.8Accounts payable 267.3 229.9Accrued income taxes 109.4 111.9Other accrued liabilities 871.5 704.0

Total current liabilities 1,322.0 1,053.6

Noncurrent LiabilitiesLong-term debt 461.5 283.6Other noncurrent liabilities 175.6 216.8

Total noncurrent liabilities 637.1 500.4

Commitments and Contingencies (see Note 15)

$6.50 Cumulative Redeemable Preferred Stock, at redemption value — 360.0

Minority interest 15.5 12.3

Stockholders’ EquityCommon stock, $.01 par value; 650,000,000 shares Class A authorized; shares issued:

150,969,807 in 2004 and 133,616,710 in 2003; 240,000,000 shares Class B authorized; shares issued and outstanding: 93,012,901 in 2004 and 107,462,533 in 2003 2.4 2.4

Paid-in capital 382.3 293.7Retained earnings 1,887.2 1,613.6Accumulated other comprehensive income (loss) 10.5 (53.1)

2,282.4 1,856.6Less: Treasury stock, at cost; 16,455,660 Class A shares at June 30, 2004 and

13,623,060 Class A shares at June 30, 2003 (548.9) (433.0)

Total stockholders’ equity 1,733.5 1,423.6

Total liabilities and stockholders’ equity $3,708.1 $3,349.9


56


CONSOLIDAT ED S TAT EMEN TS OF S TOCKHOLDER S’ EQUIT YAND COMPR EHENSIVE INCOME


STOCKHOLDERS’ EQUITYCommon stock, beginning of year $ 2.4 $ 2.4 $ 2.4

Common stock, end of year 2.4 2.4 2.4

Paid-in capital, beginning of year 293.7 268.8 258.3Stock compensation programs 88.6 24.9 10.5

Paid-in capital, end of year 382.3 293.7 268.8

Retained earnings, beginning of year 1,613.6 1,363.7 1,242.7Preferred stock dividends — (23.4) (23.4)Common stock dividends (68.5) (46.5) (47.5)Net earnings for the year 342.1 319.8 191.9

Retained earnings, end of year 1,887.2 1,613.6 1,363.7

Accumulated other comprehensive income (loss), beginning of year (53.1) (92.5) (120.5)Other comprehensive income 63.6 39.4 28.0

Accumulated other comprehensive income (loss), end of year 10.5 (53.1) (92.5)

Treasury stock, beginning of year (433.0) (80.5) (30.8)Acquisition of treasury stock (115.9) (352.5) (49.7)

Treasury stock, end of year (548.9) (433.0) (80.5)

Total stockholders’ equity $1,733.5 $1,423.6 $1,461.9

COMPREHENSIVE INCOMENet earnings $ 342.1 $ 319.8 $ 191.9

Other comprehensive income (loss):Net unrealized investment gains (losses) (0.6) 0.8 (3.0)Net derivative instrument gains (losses) 11.7 7.6 (7.1)Net minimum pension liability adjustments 16.0 (20.3) (7.9)Translation adjustments 36.5 51.3 46.0

Other comprehensive income (loss) 63.6 39.4 28.0

Total comprehensive income $ 405.7 $ 359.2 $ 219.9


57


CONSOLIDAT ED S TAT EMEN TS OF CA SH F LOWS


Cash Flows from Operating ActivitiesNet earnings $ 342.1 $ 319.8 $ 191.9Adjustments to reconcile net earnings to net cash flows provided by

operating activities from continuing operations:Depreciation and amortization 191.7 174.8 162.0Deferred income taxes 18.3 36.5 (22.6)Minority interest 8.9 6.7 4.7Non-cash stock compensation 7.9 1.5 (0.1)Non-cash portion of restructuring and other non-recurring expenses — — 58.0Discontinued operations 33.3 — 20.6Other non-cash items 0.8 0.9 0.9

Changes in operating assets and liabilities:Decrease (increase) in accounts receivable, net (18.4) 38.6 (15.4)Decrease (increase) in inventory and promotional merchandise, net (45.7) (15.7) 102.2Decrease (increase) in other assets 16.2 (15.3) (11.7)Increase (decrease) in accounts payable 29.8 (8.4) (32.6)Increase in accrued income taxes 17.3 5.4 28.8Increase in other accrued liabilities 75.5 52.7 59.6Decrease in other noncurrent liabilities (7.9) (44.4) (27.0)

Net cash flows provided by operating activities 669.8 553.1 519.3

Cash Flows from Investing ActivitiesCapital expenditures (206.5) (163.1) (203.2)Acquisition of businesses, net of acquired cash (4.4) (50.4) (18.5)Proceeds from divestitures 3.0 — —Proceeds from disposition of long-term investments — 21.0 4.7Purchases of long-term investments (0.1) — —

Net cash flows used for investing activities (208.0) (192.5) (217.0)

Cash Flows from Financing ActivitiesIncrease (decrease) in short-term debt, net (2.0) 2.9 0.6Proceeds from issuance of long-term debt, net 195.5 — 247.2Proceeds from the net settlement of treasury lock agreements 15.0 — —Repayments and redemptions of long-term debt (293.7) (135.8) (256.6)Net proceeds from employee stock transactions 61.4 16.7 7.7Payments to acquire treasury stock (115.9) (352.5) (49.7)Dividends paid to stockholders (68.5) (81.7) (71.0)Distributions made to minority holders of consolidated subsidiaries (7.8) (4.6) (1.3)

Net cash flows used for financing activities (216.0) (555.0) (123.1)

Effect of Exchange Rate Changes on Cash and Cash Equivalents 4.2 11.6 21.0

Cash flows used for discontinued operations (2.5) — —

Net Increase (Decrease) in Cash and Cash Equivalents 247.5 (182.8) 200.2Cash and Cash Equivalents at Beginning of Year 364.1 546.9 346.7

Cash and Cash Equivalents at End of Year $ 611.6 $ 364.1 $ 546.9

Supplemental disclosures of cash flow information (see Note 17)Cash paid during the year for:

Interest $ 35.9 $ 17.7 $ 17.6

Income Taxes $ 193.1 $ 134.7 $ 120.5


58


NOT ES TO CONSOLIDAT ED F INANCIAL S TAT EMEN TS

NOTE 1– DESCRIPTION OF BUSINESSThe Estée Lauder Companies Inc. manufactures, marketsand sells skin care, makeup, fragrance and hair careproducts around the world. Products are marketed underthe following brand names: Estée Lauder, Clinique,Aramis, Prescriptives, Origins, M.A.C, Bobbi Brown,La Mer, Aveda, Stila, Jo Malone, Bumble and bumble,Darphin and Rodan + Fields. The Estée Lauder CompaniesInc. is also the global licensee of the Tommy Hilfiger,Donna Karan, kate spade and Michael Kors brands forfragrances and cosmetics.

NOTE 2– SUMMARY OF SIGNIFICANTACCOUNTING POLICIESPrinciples of ConsolidationThe accompanying consolidated financial statementsinclude the accounts of The Estée Lauder Companies Inc.and its subsidiaries (collectively, the “Company”) as con-tinuing operations, with the exception of the operatingresults of its reporting unit that sold jane brand products,which have been reflected as discontinued operations forfiscal 2004, 2003 and 2002 (see Note 4). All significant inter-company balances and transactions have been eliminated.

Certain amounts in the consolidated financial state-ments of prior years have been reclassified to conform tocurrent year presentation for comparative purposes.

Net Earnings Per Common ShareFor the year ended June 30, 2004, net earnings percommon share (“basic EPS”) is computed by dividing netearnings, which includes preferred stock dividends (see“Recently Issued Accounting Standards”), by the weightedaverage number of common shares outstanding and con-tingently issuable shares (which satisfy certain conditions).For the years ended June 30, 2003 and 2002, basic EPS iscomputed by dividing net earnings, after deductingpreferred stock dividends on the Company’s $6.50Cumulative Redeemable Preferred Stock, by the weightedaverage number of common shares outstanding and con-tingently issuable shares (which satisfy certain conditions).Net earnings per common share assuming dilution(“diluted EPS”) is computed by reflecting potential dilutionfrom the exercise of stock options.

A reconciliation between the numerators and denomi-nators of the basic and diluted EPS computations is as follows:

59

YEAR ENDED JUNE 30 2004 2003 2002(In millions, except per share data)Numerator:Net earnings from continuing operations $375.4 $325.6 $212.9Preferred stock dividends — (23.4) (23.4)

Net earnings attributable to common stock from continuing operations 375.4 302.2 189.5Discontinued operations, net of tax (33.3) (5.8) (21.0)

Net earnings attributable to common stock $342.1 $296.4 $168.5

Denominator:Weighted average common shares outstanding — Basic 228.2 232.6 238.2Effect of dilutive securities: Stock options 3.4 2.1 2.9

Weighted average common shares outstanding — Diluted 231.6 234.7 241.1

Basic net earnings per common share:Net earnings from continuing operations $ 1.65 $ 1.30 $ .80Discontinued operations, net of tax (.15) (.03) (.09)

Net earnings $ 1.50 $ 1.27 $ .71

Diluted net earnings per common share:Net earnings from continuing operations $ 1.62 $ 1.29 $ .79Discontinued operations, net of tax (.14) (.03) (.09)

Net earnings $ 1.48 $ 1.26 $ .70

As of June 30, 2004, 2003 and 2002, options to purchase6.6 million, 13.6 million and 12.1 million shares, respec-tively, of Class A Common Stock were not included in thecomputation of diluted EPS because the exercise pricesof those options were greater than the average marketprice of the common stock and their inclusion would beanti-dilutive. The options were still outstanding at the endof the applicable periods.

Cash and Cash EquivalentsCash and cash equivalents include $187.2 million and$76.2 million of short-term time deposits at June 30, 2004and 2003, respectively. The Company considers all highlyliquid investments with original maturities of three monthsor less to be cash equivalents.


Accounts ReceivableAccounts receivable is stated net of the allowance fordoubtful accounts and customer deductions of $30.1 mil-lion and $31.8 million as of June 30, 2004 and 2003,respectively.

Currency Translation and TransactionsAll assets and liabilities of foreign subsidiaries andaffiliates are translated at year-end rates of exchange,while revenue and expenses are translated at weightedaverage rates of exchange for the year. Unrealized trans-lation gains or losses are reported as cumulative transla-tion adjustments through other comprehensive income.Such adjustments amounted to $36.5 million, $51.3 mil-lion and $46.0 million of unrealized translation gains infiscal 2004, 2003 and 2002, respectively.

The Company enters into forward foreign exchangecontracts and foreign currency options to hedge foreigncurrency transactions for periods consistent with itsidentified exposures. Accordingly, the Company catego-rizes these instruments as entered into for purposes otherthan trading.

The accompanying consolidated statements ofearnings include net exchange losses of $14.5 million,$15.0 million and $6.8 million in fiscal 2004, 2003 and2002, respectively.

Inventory and Promotional MerchandiseInventory and promotional merchandise only includesinventory considered saleable or usable in future periods,and is stated at the lower of cost or fair-market value, withcost being determined on the first-in, first-out method.Promotional merchandise is charged to expense at the timethe merchandise is shipped to the Company’s customers.

JUNE 30 2004 2003(In millions)

Inventory and promotional merchandise consists of:

Raw materials $148.1 $137.7Work in process 36.5 34.1Finished goods 317.7 296.6Promotional merchandise 151.2 130.6

$653.5 $599.0

Property, Plant and EquipmentProperty, plant and equipment is carried at cost less accu-mulated depreciation and amortization. For financial state-ment purposes, depreciation is provided principally onthe straight-line method over the estimated useful lives ofthe assets ranging from 3 to 40 years. Leasehold improve-ments are amortized on a straight-line basis over the

shorter of the lives of the respective leases or theexpected useful lives of those improvements.


Land $ 13.6 $ 13.5Buildings and improvements 160.9 150.8Machinery and equipment 670.7 567.8Furniture and fixtures 100.8 95.3Leasehold improvements 621.8 535.8

1,567.8 1,363.2Less accumulated depreciation and amortization 920.8 755.5

$ 647.0 $ 607.7

Depreciation and amortization of property, plant andequipment was $176.9 million, $156.3 million and $139.8million in fiscal 2004, 2003 and 2002, respectively.

Goodwill and Other Intangible AssetsThe Company follows the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141,“Business Combinations” and SFAS No. 142, “Goodwilland Other Intangible Assets.” These statements estab-lished financial accounting and reporting standards foracquired goodwill and other intangible assets. Specifically,the standards address how acquired intangible assetsshould be accounted for both at the time of acquisitionand after they have been recognized in the financialstatements. The provisions of SFAS No. 141 apply to allbusiness combinations initiated after June 30, 2001.In accordance with SFAS No. 142, intangible assets,including purchased goodwill, must be evaluated forimpairment. Those intangible assets that will continue tobe classified as goodwill or as other intangibles with indef-inite lives are no longer amortized.

In accordance with SFAS No. 142, the Company com-pleted its transitional impairment testing of intangibleassets during the first quarter of fiscal 2002. That effort,and preliminary assessments of the Company’s identifi-able intangible assets, indicated that little or no adjustmentwould be required upon adoption of this pronouncement.The impairment testing is performed in two steps: (i) theCompany determines impairment by comparing the fairvalue of a reporting unit with its carrying value, and (ii) ifthere is an impairment, the Company measures theamount of impairment loss by comparing the implied fairvalue of goodwill with the carrying amount of that good-will. Subsequent to the first quarter of fiscal 2002, withthe assistance of a third-party valuation firm, the Companyfinalized the testing of goodwill. Using conservative, butrealistic, assumptions to model the Company’s jane

60


business, the Company determined that the carrying valueof this unit was slightly greater than the derived fair value,indicating an impairment in the recorded goodwill. Todetermine fair value, the Company relied on three valua-tion models: guideline public companies, acquisitionanalysis and discounted cash flow. For goodwill valuationpurposes only, the revised fair value of this unit was allo-cated to the assets and liabilities of the business unit toarrive at an implied fair value of goodwill, based uponknown facts and circumstances, as if the acquisitionoccurred at that time. This allocation resulted in a write-down of recorded goodwill in the amount of $20.6 mil-lion, which has been reported as a component ofdiscontinued operations in the accompanying consoli-dated statements of earnings and cash flows. On a prod-uct category basis, this write-down would have primarilyimpacted the Company’s makeup category.

In February 2004, the Company sold the assets andoperations of its reporting unit that sold jane brand prod-

ucts. Prior to the sale of the business, in December 2003,the Company committed to a plan to sell such assets andoperations. At the time the decision was made, circum-stances warranted that the Company conduct an assess-ment of the tangible and intangible assets of the janebusiness. Based on this assessment, the Company deter-mined that the carrying amount of these assets as thenreflected on the Company’s consolidated balance sheetexceeded their estimated fair value. In accordance withthe assessment, the Company recorded a goodwillimpairment charge in the amount of $26.4 million forfiscal 2004, which is reported as a component of discon-tinued operations in the accompanying consolidatedstatements of earnings. This write-down primarilyimpacted the Company’s makeup product category andthe Americas region.

During fiscal 2002, the Company recorded a goodwillimpairment charge related to its Gloss.com business as acomponent of its restructuring expense (see Note 5).

61

GoodwillThe Company assigns goodwill of a reporting unit to the product category in which that reporting unit predominantlyoperates at the time of its acquisition. The change in the carrying amount of goodwill is as follows:

YEAR ENDED JUNE 30 2002 Additions Reductions 2003 Additions Reductions 2004(In millions)

Skin Care $ — $14.0 $— $ 14.0 $1.0 $ — $ 15.0Makeup 342.2 — — 342.2 — (26.4) 315.8Fragrance 15.5 — — 15.5 — — 15.5Hair Care 317.9 5.7 — 323.6 2.4 — 326.0

Total $675.6 $19.7 $— $695.3 $3.4 $(26.4) $672.3

Other Intangible AssetsOther intangible assets consist of the following:

Gross TotalCarrying Accumulated Net Book

JUNE 30, 2004 Value Amortization Value(In millions)

License agreements $40.3 $11.4 $28.9Trademarks and other 48.6 5.6 43.0Patents 0.5 0.5 —

Total $89.4 $17.5 $71.9

Gross TotalCarrying Accumulated Net Book

JUNE 30, 2003 Value Amortization Value(In millions)

License agreements $32.4 $ 8.1 $24.3Trademarks and other 46.7 6.6 40.1Patents 1.6 0.6 1.0

Total $80.7 $15.3 $65.4

Pursuant to the adoption of SFAS No. 142 and effectiveJuly 1, 2001, trademarks have been classified as indefinitelived assets, are no longer amortized and are evaluatedperiodically for impairment. The cost of other intangibleassets is amortized on a straight-line basis over their esti-mated useful lives. The aggregate amortization expensesrelated to amortizable intangible assets for the yearsended June 30, 2004, 2003 and 2002 were $4.0 million,$1.9 million and $1.5 million, respectively.

Long-Lived AssetsIn accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” long-livedassets are reviewed for impairment whenever events orchanges in circumstances indicate that the carryingamount of the assets in question may not be recoverable.An impairment would be recorded in circumstanceswhere undiscounted cash flows expected to be generatedby an asset are less than the carrying value of that asset.


Of the $10.2 million, net of tax, derivative instrument gainrecorded in OCI at June 30, 2004, $9.1 million, net of tax,related to the proceeds from the settlement of the treas-ury lock agreements upon the issuance of the 5.75%Senior Notes which will be reclassified to earnings as anoffset to interest expense over the 30-year life of the debtand $1.1 million, net of tax, related to gains from forwardand option contracts which the Company will reclassifyto earnings during the next twelve months.

Revenue RecognitionGenerally, revenues from merchandise sales are recordedat the time the product is shipped to the customer. TheCompany reports its sales levels on a net sales basis,which is computed by deducting from gross sales theamount of actual returns received and an amount estab-lished for anticipated returns. As a percent of gross sales,returns were 4.6%, 5.1% and 4.8% in fiscal 2004, 2003and 2002, respectively.

Advertising and PromotionCosts associated with advertising are expensed during theyear as incurred. Global advertising expenses, which pri-marily include television, radio and print media, and pro-motional expenses, such as products used as salesincentives, were $1,612.0 million, $1,416.1 million and$1,317.4 million in fiscal 2004, 2003 and 2002, respec-tively. These amounts include expenses relating to

purchase with purchase and gift with purchase promo-tions that are reflected in net sales and cost of sales.

Advertising and promotional expenses included inoperating expenses were $1,426.8 million, $1,217.8million and $1,113.2 million in fiscal 2004, 2003 and2002, respectively.

Research and DevelopmentResearch and development costs, which amounted to $67.2 million, $60.8 million and $61.3 million in fiscal 2004, 2003 and 2002, respectively, are expensed as incurred.

Related Party Royalties and TrademarksOn April 24, 2004, Mrs. Estée Lauder passed away. As aresult, the royalty payments made to her since 1969 in connection with the Company’s purchase of the “Estée Lauder” trademark outside the United Statesceased to accrue. Royalty payments totaling $18.8 mil-lion, $20.3 million and $16.5 million have been charged toexpense in fiscal 2004, 2003 and 2002, respectively.

Stock CompensationThe Company observes the provisions of SFAS No. 123,“Accounting for Stock-Based Compensation” (“SFAS No. 123”), by continuing to apply the provisions ofAccounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB No. 25”).

62

Accumulated Other Comprehensive Income (Loss)The components of accumulated other comprehensive income (loss) (“OCI”) included in the accompanying consolidatedbalance sheets consist of the following:


Net unrealized investment gains (losses), beginning of year $ 0.7 $ (0.1) $ 2.9Unrealized investment gains (losses) (1.0) 1.4 (5.0)Provision for deferred income taxes 0.4 (0.6) 2.0

Net unrealized investment gains (losses), end of year 0.1 0.7 (0.1)

Net derivative instruments, beginning of year (1.5) (9.1) (2.0)Gain (loss) on derivative instruments 1.6 (1.6) (16.1)Provision for deferred income taxes on derivative instruments (1.4) 0.5 5.5Reclassification to earnings during the year 17.2 13.3 5.3Provision for deferred income taxes on reclassification (5.7) (4.6) (1.8)

Net derivative instruments, end of year 10.2 (1.5) (9.1)

Net minimum pension liability adjustments, beginning of year (40.6) (20.3) (12.4)Minimum pension liability adjustments 26.6 (30.8) (11.6)Provision for deferred income taxes (10.6) 10.5 3.7

Net minimum pension liability adjustments, end of year (24.6) (40.6) (20.3)

Cumulative translation adjustments, beginning of year (11.7) (63.0) (109.0)Translation adjustments 36.5 51.3 46.0

Cumulative translation adjustments, end of year 24.8 (11.7) (63.0)

Accumulated other comprehensive income (loss) $ 10.5 $(53.1) $ (92.5)


The Company applies the intrinsic value method asoutlined in APB No. 25 and related interpretations inaccounting for stock options and share units grantedunder these programs. Under the intrinsic value method,no compensation expense is recognized if the exerciseprice of the Company’s employee stock options equalsthe market price of the underlying stock on the date of the grant. Accordingly, no compensation cost has been recognized on options granted to employees. SFASNo. 123 requires that the Company provide pro formainformation regarding net earnings and net earnings percommon share as if compensation cost for the Company’sstock option programs had been determined in accor-dance with the fair value method prescribed therein.

The Company adopted the disclosure portion of SFAS No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosure,” requiring quarterly SFAS No. 123 pro forma disclosure. The pro forma charge forcompensation cost related to stock options granted is rec-ognized over the service period. The service periodrepresents the period of time between the date of grantand the date each option becomes exercisable withoutconsideration of acceleration provisions (e.g., retirement,change of control, etc.). The following table illustrates theeffect on net earnings and earnings per common shareas if the fair value method had been applied to all out-standing awards in each period presented.

63

YEAR ENDED JUNE 30 2004(i) 2003 2002(In millions, except per share data)

Net earnings attributable to common stock, as reported $342.1 $296.4 $168.5Deduct: Total stock-based employee compensation expense determined

under fair value method for all awards, net of related tax effects 31.4 22.9 2.7

Pro forma net earnings attributable to common stock $310.7 $273.5 $165.8

Earnings per common share:Net earnings per common share — Basic, as reported $ 1.50 $ 1.27 $ .71

Net earnings per common share — Basic, pro forma $ 1.36 $ 1.18 $ .70

Net earnings per common share — Diluted, as reported $ 1.48 $ 1.26 $ .70

Net earnings per common share — Diluted, pro forma $ 1.34 $ 1.16 $ .68

(i) Fiscal 2004 pro forma compensation cost includes the acceleration of exercisability of options held by an executive who retired on June 30, 2004based on the original terms of the option grant.

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model withthe following assumptions:

YEAR ENDED JUNE 30 2004 2003 2002

Average expected volatility 31% 31% 31%Average expected option life 7 years 7 years 7 yearsAverage risk-free interest rate 3.7% 4.2% 4.9%Average dividend yield .6% .6% .5%

Concentration of Credit RiskThe Company is a worldwide manufacturer, marketer anddistributor of skin care, makeup, fragrance and hair careproducts. Domestic and international sales are made pri-marily to department stores, perfumeries and specialtyretailers. The Company grants credit to all qualified cus-tomers and does not believe it is exposed significantly toany undue concentration of credit risk.

For the fiscal years ended June 30, 2004, 2003 and2002, the Company’s three largest customers accountedfor an aggregate of 22%, 24% and 25%, respectively, of netsales. No single customer accounted for more than 10% ofthe Company’s net sales during fiscal 2004, 2003, or 2002.

Additionally, as of June 30, 2004 and 2003, the Com-pany’s three largest customers accounted for an aggre-gate of 25% and 28%, respectively, of its outstandingaccounts receivable.

Management EstimatesThe preparation of financial statements in conformity withU.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions thataffect the reported amounts of assets, liabilities, revenuesand expenses reported in those financial statements.Actual results could differ from those estimates andassumptions.


Derivative Financial InstrumentsThe Company accounts for derivative financial instru-ments in accordance with SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities,” asamended, which establishes accounting and reportingstandards for derivative instruments, including certainderivative instruments embedded in other contracts, andfor hedging activities. SFAS No. 133 also requires therecognition of all derivative instruments as either assetsor liabilities on the balance sheet and that they bemeasured at fair value.

Recently Issued Accounting StandardsOn May 19, 2004, the Financial Accounting StandardsBoard (“FASB”) issued FASB Staff Position No. FAS 106-2,“Accounting and Disclosure Requirements Related to theMedicare Prescription Drug, Improvement and Modern-ization Act of 2003” (“FSP No. 106-2”), in response to anew law regarding prescription drug benefits underMedicare (“Medicare Part D”) and a Federal subsidy tosponsors of retiree health care benefit plans that providea benefit that is at least actuarially equivalent to MedicarePart D. Currently, Statement of Financial Accounting Stan-dard No. 106, “Employers’ Accounting for PostretirementBenefits Other Than Pensions” (“SFAS No. 106”), requiresthat changes in relevant law be considered in currentmeasurement of postretirement benefit costs. FSP No.106-2 will be effective for financial statements of compa-nies for the first interim or annual period beginning afterJune 15, 2004. The Company will adopt FSP No. 106-2 inthe first quarter of fiscal 2005 and will recognize theimpact of the new law under Medicare Part D, which willnot be material to the Company’s results of operations,cash flows, or financial condition. Therefore, any measuresof the accumulated postretirement benefit obligation orthe net periodic postretirement benefit cost as of and forthe year ended June 30, 2004 do not reflect the effects ofthe new law.

In December 2003, the FASB issued FASB Interpreta-tion Number 46-R (“FIN 46-R”), “Consolidation of Vari-able Interest Entities.” FIN 46-R, which modifies certainprovisions and effective dates of FIN 46, sets forth criteriato be used in determining whether an investment in a vari-able interest entity should be consolidated. These provi-sions are based on the general premise that if a companycontrols another entity through interests other than vot-ing interests, that company should consolidate the con-trolled entity. The Company has evaluated whether theprovisions of FIN 46-R are applicable to its investments,certain of which are currently accounted for by the equity

method, as well as other arrangements, which maymeet the criteria of the interpretation, and believes thatthere are currently no material arrangements that meetthe definition of a variable interest entity which wouldrequire consolidation.

In December 2003, the FASB revised SFAS No. 132(Revised 2003), “Employers’ Disclosures about Pensionsand other Postretirement Benefits” (“SFAS No. 132 (R)”),establishing additional annual disclosures about planassets, investment strategy, measurement date, plan obli-gations and cash flows. In addition, the revised standardestablished interim disclosure requirements related to thenet periodic benefit cost recognized and contributionspaid or expected to be paid during the current fiscal year.The new annual disclosures are effective for financialstatements of companies with fiscal years ending afterDecember 15, 2003 and the interim-period disclosuresare effective for interim periods beginning after Decem-ber 15, 2003. The Company adopted the interim disclo-sures for the fiscal quarter ended March 31, 2004 and theannual disclosures for the year ended June 30, 2004. Theadoption of the revised SFAS No. 132 (R) had no impacton the results of operations or financial condition.

The Company adopted SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of bothLiabilities and Equity” (“SFAS No. 150”). SFAS No. 150established standards for classifying and measuring cer-tain financial instruments with characteristics of both lia-bilities and equity. Among other things, it specificallyrequires that mandatorily redeemable instruments, suchas redeemable preferred stock, be classified as a liability.Initial and subsequent measurements of the instrumentsdiffer based on the characteristics of each instrument and as provided for in the statement. Based on the provi-sions of this statement, the Company has classified itsredeemable preferred stock as a liability in fiscal 2004 andthe related dividends thereon have been characterized asinterest expense. Restatement of financial statements forearlier years presented was not permitted. The adoptionof this statement has resulted in the inclusion of the divi-dends on the preferred stock (equal to $17.4 million forthe year ended June 30, 2004) as interest expense. Whilethe inclusion has impacted net earnings, net earningsattributable to common stock and earnings per commonshare were unaffected. Given that the dividends are notdeductible for income tax purposes, the inclusion of thepreferred stock dividends as an interest expense hascaused an increase in our effective tax rate for fiscal 2004.The adoption of SFAS No. 150 had no impact on theCompany’s financial condition.

64


NOTE 3 – PUBLIC OFFERINGSIn June 2004, three Lauder family trusts sold a total of13,000,000 shares of Class A Common Stock in a regis-tered public offering. The Company did not receive anyproceeds from the sales of these shares. The cost of thisoffering was borne by the selling stockholders.

During October 2001, a member of the Lauder familysold 5,000,000 shares of Class A Common Stock in a reg-istered public offering. The Company did not receive anyproceeds from the sale of these shares. The cost of thisoffering was borne by the selling stockholder.

NOTE 4 – ACQUISITION AND DIVESTITURE OFBUSINESSES AND LICENSE ARRANGEMENTSIn December 2003, the Company committed to a plan tosell the assets and operations of its reporting unit that soldjane brand products and sold them in February 2004. Atthe time the decision was made, circumstances warrantedthat the Company conduct an assessment of the tangibleand intangible assets of the jane business. Based on thisassessment, the Company determined that the carryingamount of these assets as then reflected on the Com-pany’s consolidated balance sheet exceeded its estimatedfair value. In accordance with the assessment and the clos-ing of the sale, the Company recorded an after-tax chargeto discontinued operations of $33.3 million for the fiscalyear ended June 30, 2004. The charge represents theimpairment of goodwill in the amount of $26.4 million;the reduction in value of other tangible assets in theamount of $2.1 million, net of taxes; and the reportingunit’s operating loss of $4.8 million, net of tax. Includedin the operating loss of the fiscal year were additionalcosts associated with the sale and discontinuation of thebusiness. As a result, all consolidated statements of earn-ings information in the consolidated financial statementsand footnotes for fiscal 2003 and 2002 has been restatedfor comparative purposes to reflect that reporting unit asdiscontinued operations, including the restatement of themakeup product category and the Americas region datapresented in Note 18.

In July 2003, the Company acquired the Rodan + Fieldsskin care line. The initial purchase price, paid at closing,was funded by cash provided by operations, the paymentof which did not have a material effect on the Company’sresults of operations or financial condition. The Companyexpects to make additional payments between fiscal2007 and 2011 based on certain conditions.

On April 30, 2003, the Company completed the acqui-sition of the Paris-based Darphin group of companies thatdevelops, manufactures and markets the “Darphin” brandof skin care and makeup products. The initial purchase

price, paid at closing, was funded by cash provided byoperations, the payment of which did not have a materialeffect on the Company’s results of operations or financialcondition. An additional payment is expected to be madein fiscal 2009, the amount of which will depend on futurenet sales and earnings of the Darphin business.

At various times during fiscal 2004, 2003 and 2002, theCompany acquired businesses engaged in the wholesaledistribution and retail sale of Aveda products, as well asother products, in the United States and other countries.In fiscal 2002, the Company purchased an Aveda whole-sale distributor business in Korea and acquired the minorityinterest of its Aveda joint venture in the United Kingdom.

The aggregate purchase price for these transactions,which includes acquisition costs, was $4.4 million, $50.4million, and $18.5 million in fiscal 2004, 2003 and 2002,respectively, and each transaction was accounted forusing the purchase method of accounting. Accordingly,the results of operations for each of the acquired busi-nesses are included in the accompanying consolidatedfinancial statements commencing with its date of originalacquisition. Pro forma results of operations, as if each ofsuch businesses had been acquired as of the beginningof the year of acquisition, have not been presented, as theimpact on the Company’s consolidated financial resultswould not have been material.

In May 2003, the Company entered into a licenseagreement for fragrances and beauty products under the“Michael Kors” trademarks with Michael Kors L.L.C. andpurchased certain related rights and inventory fromAmerican Designer Fragrances, a division of LVMH.

NOTE 5 – RESTRUCTURING AND SPECIAL CHARGESFiscal 2003During the fourth quarter of fiscal 2003, the Companyrecorded a special pre-tax charge of $22.0 million, or$13.5 million after tax, equal to $.06 per diluted commonshare, in connection with the proposed settlement of alegal proceeding brought against a number of defendantsincluding the Company (see Note 15). The amount of thecharge in this case is significantly larger than similarcharges the Company has incurred individually or in theaggregate for legal proceedings in any prior year.

Fiscal 2002During the fourth quarter of fiscal 2002, the Companyrecorded a restructuring charge related to repositioningcertain businesses as part of its ongoing efforts to drive long-term growth and increase profitability. Therestructuring focused on cost reduction opportunitiesrelated to the Internet, supply chain, globalization of the

65


organization and distribution channel refinements. TheCompany committed to a defined plan of action, whichresulted in an aggregate pre-tax charge of $117.4 million,of which $0.8 million was included in discontinuedoperations, and $59.4 million was cash related. On anafter-tax basis, the aggregate charge was $76.9 million, ofwhich $0.5 million was included in discontinued opera-tions, equal to $.32 per diluted share.

Specifically, the charge includes the following:

• Internet. In an effort to achieve strategic objectives,reduce costs and improve profitability, the Company out-sourced Gloss.com platform development and mainte-nance efforts to a third-party provider. Additionally,Gloss.com closed its San Francisco facility and consoli-dated its operations in New York. As a result, included inthe charge is a $23.9 million provision for restructuringthe Gloss.com operations, including benefits and sever-ance packages for 36 employees as well as asset write-offs. The Company also took a $20.1 million charge towrite off the related Gloss.com acquisition goodwill.

• Supply Chain. Building on previously announced supplychain initiatives, the Company restructured certainmanufacturing, distribution, research and development,

information systems and quality assurance operations inthe United States, Canada and Europe, which includedbenefits and severance packages for 110 employees.A charge of $23.7 million was recorded related to this effort.

• Globalization of Organization. The Company contin-ued to implement its transition, announced in fiscal 2001,to a global brand structure designed to streamline thedecision making process and increase innovation andspeed-to-market. The next phase of this transition entailedeliminating duplicate functions and responsibilities, whichresulted in charges for benefits and severance for 122employees. The Company recorded a charge of $27.1million associated with these efforts.

• Distribution. The Company evaluated areas of distribu-tion relative to its financial targets and decided to focus itsresources on the most productive sales channels and mar-kets. As a result, the Company closed its operations inArgentina and the remaining customers are being serv-iced by the Company’s Chilean affiliate. The Companybegan closing all remaining in-store “tommy’s shops” andother select points of distribution. The Company recordeda $22.6 million provision related to these actions, whichincluded benefits and severance for 85 employees.

66

Following is a summary of the charges as recorded in the consolidated statement of earnings for fiscal 2002:

Net Sales Cost of Sales Operating Expenses Total(In millions)

Internet $ — $ — $ 44.0 $ 44.0Supply chain — — 23.7 23.7Globalization of organization — — 27.1 27.1Distribution 6.2 0.8 15.6 22.6

Total charge $6.2 $0.8 $110.4 117.4

Tax effect (40.5)

Net charge $ 76.9

Restructuring

The fiscal 2002 restructuring charge was recorded inother accrued liabilities or, where applicable, as a reduc-tion of the related asset. During fiscal 2004, 2003 and2002, $12.3 million, $32.2 million and $9.3 million,respectively, related to this restructuring was paid. As ofJune 30, 2004 and 2003, the restructuring accrualbalance was $9.4 million and $21.9 million, respectively,and the Company expects to settle a majority of theremaining obligations by the end of fiscal 2005 withcertain additional payments made in fiscal 2006.

During the fourth quarter of fiscal 2001, the Companyrecorded one-time charges for restructuring and specialcharges. As of June 30, 2004 and 2003, the remainingobligation was $1.3 million and $2.6 million, respectively,with remaining payments to be made ratably throughfiscal 2007.


NOTE 6 – INCOME TAXESThe provision for income taxes is comprised of the following:


Current:Federal $ 67.1 $ 37.6 $ 38.6Foreign 135.5 84.0 92.2State and local 11.7 5.2 6.5

214.3 126.8 137.3

Deferred:Federal 20.1 33.5 (13.2)Foreign (1.8) 1.9 (8.9)State and local — 1.1 (0.5)

18.3 36.5 (22.6)

$232.6 $163.3 $114.7

A reconciliation between the provision for income taxescomputed by applying the statutory Federal income taxrate to earnings before income taxes and minority interestand the actual provision for income taxes is as follows:


Provision for income taxes at statutory rate $215.9 $173.4 $116.3

Increase (decrease) due to:State and local income taxes,net of Federal tax benefit 7.6 3.9 4.0

Effect of foreign operations (2.8) (1.0) (0.9)Preferred stock dividends not deductible for U.S. tax purposes 6.1 — —

Other nondeductible expenses 2.7 1.7 3.2Tax credits (1.3) (12.5) (2.1)Other, net 4.4 (2.2) (5.8)

Provision for income taxes $232.6 $163.3 $114.7

Effective tax rate 37.7% 32.9% 34.5%

67

Significant components of the Company’s deferred income tax assets and liabilities as of June 30, 2004 and 2003 were as follows:

2004 2003(In millions)

Deferred tax assets:Deferred compensation and other payroll related expenses $ 69.5 $ 55.4Inventory obsolescence and other inventory related reserves 56.7 55.9Pension plan reserves — 7.1Postretirement benefit obligations 21.0 22.9Various accruals not currently deductible 83.1 76.4Net operating loss and credit carryforwards 5.7 16.3Other differences between tax and financial statement values 7.3 8.0

243.3 242.0Valuation allowance for deferred tax assets (4.2) (2.9)

Total deferred tax assets 239.1 239.1

Deferred tax liabilities:Depreciation and amortization (102.2) (84.0)Prepaid pension costs (10.1) —Other differences between tax and financial statement values (7.7) (0.4)

Total deferred tax liabilities (120.0) (84.4)

Total net deferred tax assets $ 119.1 $154.7

As of June 30, 2004 and 2003, the Company had currentnet deferred tax assets of $145.9 million and $116.0 mil-lion, respectively, which are included in prepaid expensesand other current assets in the accompanying consoli-dated balance sheets. In addition, the Company had non-current net deferred tax liabilities of $26.8 million as ofJune 30, 2004 and noncurrent net deferred tax assets of$38.7 million as of June 30, 2003, which are included inother noncurrent liabilities and other assets, net, respec-tively, in the accompanying consolidated balance sheets.

Federal income and foreign withholding taxes have notbeen provided on $560.5 million, $476.6 million and$473.5 million of undistributed earnings of internationalsubsidiaries at June 30, 2004, 2003 and 2002, respec-tively. The Company intends to reinvest these earnings inits foreign operations indefinitely, except where it is ableto repatriate these earnings to the United States withoutmaterial incremental tax provision.


As of June 30, 2004 and 2003, certain internationalsubsidiaries had tax loss carryforwards for local tax pur-poses of approximately $24.5 million and $14.7 million,respectively. With the exception of $12.1 million of losseswith an indefinite carryforward period as of June 30,2004, these losses expire at various dates through fiscal2017. Deferred tax assets in the amount of $5.7 millionand $2.9 million as of June 30, 2004 and 2003, respec-tively, have been recorded to reflect the tax benefits ofthe losses not utilized to date. A full valuation allowancehas been provided for those deferred tax assets for which,in the opinion of management, it is more likely than notthat the deferred tax assets will not be realized.

Earnings before income taxes and minority interestinclude amounts contributed by the Company’s inter-national operations of $523.0 million, $393.1 million and $283.4 million for fiscal 2004, 2003 and 2002,respectively. Some of these earnings are taxed in theUnited States.

Furthermore, the Company provides tax reserves forFederal, state and international exposures relating to auditresults, planning initiatives and compliance responsi-bilities. The development of these reserves requiresjudgments about tax issues, potential outcomes andtiming, and is a subjective critical estimate.

NOTE 7 – OTHER ACCRUED LIABILITIESOther accrued liabilities consist of the following:


Advertising and promotional accruals $290.2 $276.0Employee compensation 236.9 191.1Restructuring and special charges 32.7 46.5Other 311.7 190.4

$871.5 $704.0

68

NOTE 8 – DEBTThe Company’s short-term and long-term debt and available financing consist of the following:

Debt at June 30

Available financing at June 30

2004 2003 2004 2003 2004 2003

(In millions)

6.00% Senior Notes, due January 15, 2012 $236.6 $257.1 $ — $ — $ — $ —5.75% Senior Notes, due October 15, 2033 197.3 — — — — —1.45% Japan loan payable, due on March 28, 2006 27.6 25.2 — — — —

2015 Preferred Stock 68.4 — — — — —Other long-term borrowings — 1.3 — — — —Other short-term borrowings 5.4 7.8 — — 167.9 156.6Commercial paper — — — — 750.0 750.0Revolving credit facility — — 400.0 400.0 — —Shelf registration for debt securities — — — — 300.0 500.0

535.3 291.4 $400.0 $400.0 $1,217.9 $1,406.6

Less current maturities (73.8) (7.8)

$461.5 $283.6

UncommittedCommitted

In September 2003, the Company issued and sold $200.0million of 5.75% Senior Notes due October 2033 (“5.75%Senior Notes”) in a public offering. The 5.75% SeniorNotes were priced at 98.645% with a yield of 5.846%.Interest payments, which commenced April 15, 2004,are required to be made semi-annually on April 15 andOctober 15 of each year. In May 2003, in anticipation ofthe issuance of the 5.75% Senior Notes, the Companyentered into a series of treasury lock agreements on a

notional amount totaling $195.0 million at a weightedaverage all-in rate of 4.53%. The treasury lock agreementswere settled upon the issuance of the new debt and theCompany received a payment of $15.0 million that willbe amortized against interest expense over the life of the5.75% Senior Notes. As a result of the treasury lock agree-ments, the debt discount and debt issuance costs, theeffective interest rate on the 5.75% Senior Notes will be5.395% over the life of the debt.


As of June 30, 2004, the Company had outstanding$236.6 million of 6% Senior Notes due January 2012(“6% Senior Notes”) consisting of $250.0 million princi-pal, an unamortized debt discount of $0.9 million, and a$12.5 million adjustment to reflect the fair value of an out-standing interest rate swap. The 6% Senior Notes, whenissued in January 2002, were priced at 99.538% with ayield of 6.062%. Interest payments are required to bemade semi-annually on January 15 and July 15 of eachyear. In May 2003, the Company entered into an interestrate swap agreement with a notional amount of $250.0million to effectively convert the fixed rate interest on ouroutstanding 6% Senior Notes to variable interest ratesbased on six-month LIBOR.

In the first quarter of fiscal 2004, the Companyadopted SFAS No. 150 (see Note 2— Recently IssuedAccounting Standards) which required that theCompany’s cumulative redeemable preferred stock beclassified as a liability and the related dividends thereon asinterest expense. Restatement of financial statements forfiscal 2003 was not permitted. During fiscal 2004, theCompany and the holders of the $6.50 CumulativeRedeemable Preferred Stock exchanged all of the out-standing shares due June 30, 2005 for a newly issuedseries of cumulative redeemable preferred stock with a mandatory redemption date of June 30, 2015 (“2015Preferred Stock”) with a variable dividend rate. Thisexchange transaction has been accounted for as a modi-fication of the terms of the cumulative redeemable pre-ferred stock, and accordingly, the effects of thistransaction on the Company’s operating results have beenlimited to the prospective change in dividend rates. Suchdividends have preference over all other dividends of stock issued by the Company. On April 24, 2004,Mrs. Estée Lauder passed away. As a result, the Company’sright to call for redemption $291.6 million of the 2015Preferred Stock became exercisable and the Companyexercised this right for cash in June 2004. Upon this par-tial redemption, the dividend rate on the remaining $68.4million principal amount of the 2015 Preferred Stock was reduced, for the period from April 25, 2004 throughJune 30, 2004, from 4.75% per annum to 0.62% perannum, which is a rate based on the after-tax yield on six-month U.S. Treasuries. So long as the remaining shares of2015 Preferred Stock are outstanding, the dividend ratewill be reset semi-annually in January and July at the then-existing after-tax yield on six-month U.S. Treasuries. Thedividend rate for the six-month period from July 1, 2004through December 31, 2004 is 0.994%. The $68.4 mil-lion 2015 Preferred Stock may be put to the Company atany time at face value but may not be redeemed by the

Company until May 24, 2005. As a result, the liability isrecorded at its redemption value and is classified as cur-rent at June 30, 2004.

As of June 30, 2003, other long-term borrowingsconsisted primarily of several term loans held by theDarphin group of companies, which was acquired by theCompany in April 2003 (see Note 4). These loans had var-ious maturities through July 2007 with variable and fixedinterest rates ranging from 2.5% to 5.8%. All of theseloans were repaid during fiscal 2004.

The Company maintains uncommitted credit facilitiesin various regions throughout the world. Interest rateterms for these facilities vary by region and reflect pre-vailing market rates for companies with strong credit rat-ings. During fiscal 2004 and 2003, the monthly averageamount outstanding was approximately $5.1 million and$1.4 million, respectively, and the annualized monthlyweighted average interest rate incurred was approxi-mately 5.7% and 5.4%, respectively.

Effective June 28, 2001, the Company entered into afive-year $400.0 million revolving credit facility, expiringon June 28, 2006, which includes an annual fee of .07%on the total commitment. At June 30, 2004 and 2003, theCompany was in compliance with all related financial andother restrictive covenants, including limitations onindebtedness and liens. The Company also had an effec-tive shelf registration statement covering the potentialissuance of up to $300.0 million and $500.0 million indebt securities at June 30, 2004 and 2003, respectively,and a $750.0 million commercial paper program underwhich the Company may issue commercial paper in theUnited States.

NOTE 9 – FINANCIAL INSTRUMENTSDerivative Financial InstrumentsThe Company addresses certain financial exposuresthrough a controlled program of risk management thatincludes the use of derivative financial instruments. TheCompany primarily enters into foreign currency forwardexchange contracts and foreign currency options toreduce the effects of fluctuating foreign currencyexchange rates. The Company, if necessary, enters intointerest rate derivatives to manage the effects of interestrate movements on the Company’s aggregate liabilityportfolio. The Company categorizes these instruments asentered into for purposes other than trading.

All derivatives are recognized on the balance sheet attheir fair value. On the date the derivative contract isentered into, the Company designates the derivative as (i) a hedge of the fair value of a recognized asset or lia-bility or of an unrecognized firm commitment (“fair value”

69


hedge), (ii) a hedge of a forecasted transaction or of thevariability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge),(iii) a foreign-currency fair-value or cash-flow hedge (“foreign currency” hedge), (iv) a hedge of a net invest-ment in a foreign operation, or (v) other. Changes in thefair value of a derivative that is highly effective as (and thatis designated and qualifies as) a fair-value hedge, alongwith the loss or gain on the hedged asset or liability that isattributable to the hedged risk (including losses or gainson firm commitments), are recorded in current-periodearnings. Changes in the fair value of a derivative that ishighly effective as (and that is designated and qualifies as)a cash-flow hedge are recorded in other comprehensiveincome, until earnings are affected by the variability ofcash flows (e.g., when periodic settlements on a variable-rate asset or liability are recorded in earnings). Changes inthe fair value of derivatives that are highly effective as (andthat are designated and qualify as) foreign-currencyhedges are recorded in either current-period earnings orother comprehensive income, depending on whether thehedge transaction is a fair-value hedge (e.g., a hedge ofa firm commitment that is to be settled in a foreigncurrency) or a cash-flow hedge (e.g., a foreign-currency-denominated forecasted transaction). If, however, a deriv-ative is used as a hedge of a net investment in a foreignoperation, its changes in fair value, to the extent effectiveas a hedge, are recorded in accumulated other compre-hensive income within equity. Furthermore, changes in thefair value of other derivative instruments are reported incurrent-period earnings.

For each derivative contract entered into where theCompany looks to obtain special hedge accounting treat-ment, the Company formally documents all relationshipsbetween hedging instruments and hedged items, as wellas its risk-management objective and strategy for under-taking the hedge transaction. This process includes linkingall derivatives that are designated as fair-value, cash-flow,or foreign-currency hedges to specific assets and liabili-ties on the balance sheet or to specific firm commitmentsor forecasted transactions. The Company also formallyassesses, both at the hedge’s inception and on an ongoingbasis, whether the derivatives that are used in hedgingtransactions are highly effective in offsetting changes infair values or cash flows of hedged items. If it is deter-mined that a derivative is not highly effective, or that it hasceased to be a highly effective hedge, the Company willbe required to discontinue hedge accounting withrespect to that derivative prospectively.

Foreign Exchange Risk ManagementThe Company enters into forward exchange contracts tohedge anticipated transactions as well as receivables andpayables denominated in foreign currencies for periodsconsistent with the Company’s identified exposures. Thepurpose of the hedging activities is to minimize the effectof foreign exchange rate movements on costs and on thecash flows that the Company receives from foreign sub-sidiaries. Almost all foreign currency contracts are denom-inated in currencies of major industrial countries and arewith large financial institutions rated as strong investmentgrade by a major rating agency. The Company also entersinto foreign currency options to hedge anticipated trans-actions where there is a high probability that anticipatedexposures will materialize. The forward exchange con-tracts and foreign currency options entered into to hedgeanticipated transactions have been designated as cash-flow hedges. As of June 30, 2004, these cash-flow hedgeswere highly effective, in all material respects.

As a matter of policy, the Company only enters intocontracts with counterparties that have at least an “A” (orequivalent) credit rating. The counterparties to these con-tracts are major financial institutions. The Company doesnot have significant exposure to any one counterparty.Exposure to credit loss in the event of nonperformanceby any of the counterparties is limited to only the recog-nized, but not realized, gains attributable to the contracts.Management believes risk of loss under these hedgingcontracts is remote and in any event would not be mate-rial to the Company’s consolidated financial results. Thecontracts have varying maturities through the end of June2005. Costs associated with entering into such contractshave not been material to the Company’s consolidatedfinancial results. The Company does not utilize derivativefinancial instruments for trading or speculative purposes.At June 30, 2004, we had foreign currency contracts inthe form of forward exchange contracts and option con-tracts in the amount of $593.6 million and $82.0 million,respectively. The foreign currencies included in forwardexchange contracts (notional value stated in U.S. dollars)are principally the Euro ($122.6 million), Swiss franc($117.1 million), British pound ($72.8 million), Japaneseyen ($66.7 million), South Korean won ($42.0 million),Canadian dollar ($41.7 million), and Australian dollar($33.7 million). The foreign currencies included in theoption contracts (notional value stated in U.S. dollars) areprincipally the Euro ($34.1 million), British pound ($25.4million), and Swiss franc ($12.7 million). At June 30, 2003,the Company had foreign currency contracts in the form

70


of forward exchange contracts and option contracts in theamount of $476.7 million and $57.7 million, respectively.The foreign currencies included in forward exchange con-tracts (notional value stated in U.S. dollars) are principallythe Euro ($114.0 million), Swiss franc ($61.9 million),Japanese yen ($56.0 million), British pound ($49.8 mil-lion), Canadian dollar ($37.7 million), South Korean won($37.6 million) and Australian dollar ($30.6 million). Theforeign currencies included in the option contracts(notional value stated in U.S. dollars) are principally theSwiss franc ($21.9 million), Canadian dollar ($21.0 million)and Euro ($11.7 million).

Interest Rate Risk ManagementThe Company enters into interest rate derivative contractsto manage the exposure to fluctuations of interest rateson its funded and unfunded indebtedness, as well as cashinvestments, for periods consistent with the identifiedexposures. All interest rate derivative contracts are withlarge financial institutions rated as strong investmentgrade by a major rating agency.

In May 2003, the Company entered into an interestrate swap agreement with a notional amount of $250.0million to effectively convert fixed interest on the existing6% Senior Notes to a variable interest rate based on six-month LIBOR. The interest rate swap was designated as afair value hedge. As of June 30, 2004, the fair value hedgewas highly effective, in all material respects.

71

Information regarding the interest rate swap is presented in the following table:

Notional NotionalAmount Pay Rate Receive Rate Amount Pay Rate Receive Rate


Interest rate swap $250.0 3.14% 6.00% $250.0 3.21% 6.00%

Weighted AverageWeighted Average

YEAR ENDED OR AT JUNE 30, 2003YEAR ENDED OR AT JUNE 30, 2004

Additionally, in May 2003, in anticipation of the issuanceof the 5.75% Senior Notes, the Company entered into aseries of treasury lock agreements on a notional amounttotaling $195.0 million at a weighted average all-in rate of4.53%. The treasury lock agreements were settled uponthe issuance of the new debt and the Company receiveda payment of $15.0 million that will be amortized againstinterest expense over the life of the 5.75% Senior Notes.

Fair Value of Financial InstrumentsThe following methods and assumptions were used toestimate the fair value of each class of financial instru-ments for which it is practicable to estimate that value:

Cash and cash equivalents:The carrying amount approximates fair value, primarilybecause of the short maturity of cash equivalentinstruments.

Long-term debt:The fair value of the Company’s long-term debt was esti-mated based on the current rates offered to the Companyfor debt with the same remaining maturities.

In fiscal 2004, the fair value of redeemable preferredstock was estimated based on a recent private transactionand is included in the current portion of long-term debtpursuant to the provisions of SFAS No. 150.

Cumulative redeemable preferred stock:In fiscal 2003, the fair value of the cumulative redeemablepreferred stock was estimated utilizing a cash flow analy-sis at a discount rate equal to rates available for debt withterms similar to the preferred stock.

Foreign exchange and interest rate contracts:The fair value of forwards, swaps, options and treasury ratelocks is the estimated amount the Company wouldreceive or pay to terminate the agreements.


NOTE 10 – PENSION, DEFERRED COMPENSATIONAND POSTRETIREMENT BENEFIT PLANSThe Company maintains pension plans covering substan-tially all of its full-time employees for its U.S. operationsand a majority of its international operations. Several plansprovide pension benefits based primarily on years of serv-ice and employees’ earnings. In certain instances, theCompany adjusts benefits in connection with internationalemployee transfers.

Retirement Growth Account Plan (U.S.)The Retirement Growth Account Plan is a trust-based,noncontributory defined benefit pension plan. The Com-pany’s funding policy consists of an annual contributionat a rate that provides for future plan benefits and main-tains appropriate funded percentages. Such contributionis not less than the minimum required by the EmployeeRetirement Income Security Act of 1974, as amended,(“ERISA”) and subsequent pension legislation and is notmore than the maximum amount deductible for incometax purposes.

Restoration Plan (U.S.)The Company also has an unfunded, nonqualified domes-tic noncontributory pension Restoration Plan to providebenefits in excess of Internal Revenue Code limitations.

International Pension PlansThe Company maintains International Pension Plans, themost significant of which are defined benefit pensionplans. The Company’s funding policies for these plans aredetermined by local laws and regulations.

Postretirement BenefitsThe Company maintains a domestic postretirementbenefit plan which provides certain medical and dentalbenefits to eligible employees. Employees hired afterJanuary 1, 2002 are not eligible for retiree medical bene-fits when they retire. Certain retired employees who arereceiving monthly pension benefits are eligible for partic-ipation in the plan. Contributions required and benefitsreceived by retirees and eligible family members aredependent on the age of the retiree. It is the Company’spractice to fund these benefits as incurred. The cost ofthe Company-sponsored programs is not significant.

Certain of the Company’s international subsidiaries and affiliates have postretirement plans, although mostparticipants are covered by government-sponsored oradministered programs.

72

The estimated fair values of the Company’s financial instruments are as follows:

JUNE 30, 2004 JUNE 30, 2003

Carrying Amount Fair Value Carrying Amount Fair Value(In millions)

NonderivativesCash and cash equivalents $611.6 $611.6 $364.1 $364.1Long-term debt, including current portion 535.3 545.5 291.4 320.9Cumulative redeemable preferred stock — — 360.0 389.8DerivativesForward exchange contracts 1.7 1.7 (6.5) (6.5)Foreign currency option contracts 2.7 2.7 3.6 3.6Interest rate swap contract (12.5) (12.5) 8.1 8.1Treasury rate lock contracts — — 2.6 2.6


The significant components of the above mentioned plans as of and for the year ended June 30 are summarized as follows:

Other thanPension Plans Pension Plans

2004 2003 2004 2003 2004 2003

(In millions)

Change in benefit obligation:Benefit obligation at beginning of year $358.7 $310.3 $191.0 $154.7 $ 61.8 $ 43.7

Service cost 16.9 15.1 10.4 8.5 3.2 2.2Interest cost 20.0 21.2 8.3 8.1 3.8 3.2Plan participant contributions — — 1.2 1.1 0.1 0.1Actuarial loss (gain) (7.7) 19.8 (7.5) 18.9 (2.8) 14.5Foreign currency exchange rate impact — — 13.3 15.0 — —Benefits paid (13.5) (11.5) (9.3) (6.0) (2.1) (1.9)Plan amendments — 3.8 0.2 — — —Special termination benefits — — 1.5 — — —Acquisitions, divestitures, adjustments — — 2.0 — — —Settlements and curtailments — — (3.7) (9.3) — —

Benefit obligation at end of year $374.4 $358.7 $207.4 $191.0 $ 64.0 $ 61.8

Change in plan assets:Fair value of plan assets at beginning of year $277.4 $201.8 $120.9 $116.3 $ — $ —

Actual return on plan assets 42.0 9.3 13.6 (13.2) — —Foreign currency exchange rate impact — — 9.0 9.9 — —Employer contributions 35.5 77.8 22.9 16.4 2.0 1.8Plan participant contributions — — 1.2 1.1 0.1 0.1Settlements and curtailments — — (3.7) (3.6) — —Benefits paid from plan assets (13.5) (11.5) (9.3) (6.0) (2.1) (1.9)

Fair value of plan assets at end of year $341.4 $277.4 $154.6 $120.9 $ — $ —

Funded status $ (33.0) $ (81.3) $ (52.8) $ (70.1) $(64.0) $(61.8)Unrecognized net actuarial loss 92.8 128.1 63.5 73.4 3.4 6.4Unrecognized prior service cost 7.2 7.6 2.4 2.4 (0.1) (0.2)Unrecognized net transition obligation — — 0.1 0.3 — —

Prepaid (accrued) benefit cost $ 67.0 $ 54.4 $ 13.2 $ 6.0 $(60.7) $(55.6)

Amounts recognized in the Balance Sheet consist of:Prepaid benefit cost $118.5 $101.5 $ 26.0 $ 12.9 $ — $ —Accrued benefit liability (52.8) (56.4) (47.8) (60.6) (60.7) (55.6)Intangible asset 0.7 0.7 0.4 0.5 — —Minimum pension liability 0.6 8.6 34.6 53.2 — —

Net amount recognized $ 67.0 $ 54.4 $ 13.2 $ 6.0 $(60.7) $(55.6)

PostretirementInternationalU.S.


Other than Pension Plans Pension Plans

2004 2003 2002 2004 2003 2002 2004 2003 2002(In millions)

Components of net periodic benefit cost:

Service cost, net $ 16.9 $ 15.1 $ 13.5 $ 10.4 $ 8.5 $ 8.0 $3.2 $ 2.2 $ 1.8Interest cost 20.0 21.2 20.6 8.3 8.1 7.2 3.8 3.2 2.9Expected return on assets (20.6) (18.3) (17.3) (9.9) (9.2) (8.3) — — —Amortization of:

Transition (asset) obligation — (1.5) (1.5) 0.3 0.3 0.2 — — —Prior service cost 0.5 0.2 0.4 0.3 0.2 0.2 — — —Actuarial loss (gain) 6.2 5.1 2.6 3.3 1.5 1.0 0.3 (0.1) (0.4)Special termination benefits — — — 1.5 — — — — —Settlements and curtailments — — — 0.7 2.3 — — — —

Net periodic benefit cost $ 23.0 $ 21.8 $ 18.3 $ 14.9 $11.7 $ 8.3 $7.3 $ 5.3 $ 4.3

Weighted-average assumptionsused to determine benefit obligations at June 30:

Pre-retirement discount rate 6.00% 5.75% 7.00% 2.25– 2.25– 2.75– 6.00% 5.75% 7.00%6.00% 6.00% 7.00%

Postretirement discount rate 5.00% 4.75% 5.75% 2.25– 2.25– 2.75– 6.00% 5.75% 7.00%6.00% 6.00% 7.00%

Rate of compensation increase 3.00– 3.00– 4.50– 1.75– 1.75– 1.75– N/A N/A N/A9.50% 9.50% 11.00% 4.00% 3.75% 4.00%

Weighted-average assumptionsused to determine net periodic benefit cost for the year ending June 30:

Pre-retirement discount rate 5.75% 7.00% 7.50% 2.25– 2.75– 3.00– 5.75% 7.00% 7.50%6.00% 7.00% 7.25%

Postretirement discount rate 4.75% 5.75% 6.00% 2.25– 2.75– 3.00– 5.75% 7.00% 7.50%6.00% 7.00% 7.25%

Expected return on assets 8.00% 8.50% 9.00% 3.25– 4.50– 5.00– N/A N/A N/A7.50% 8.25% 8.50%

Rate of compensation increase 3.00– 4.50– 5.00– 1.75– 1.75– 2.00– N/A N/A N/A9.50% 11.00% 11.50% 3.75% 4.00% 5.50%

In determining the long-term rate of return for a plan, the Company considers the historical rates of return, the nature ofthe plan’s investments and an expectation for the plan’s investment strategies.

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates for fiscal 2004 would have had the following effects:

One-Percentage-Point Increase One-Percentage-Point Decrease(In millions)

Effect on total service and interest costs $1.0 $(0.9)

Effect on postretirement benefit obligations $7.0 $(6.3)



The projected benefit obligation, accumulated benefit obligation, fair value of plan assets and the other comprehensiveloss due to change in minimum liability recognition for the Company’s pension plans at June 30 are as follows:

Pension Plans

2004 2003 2004 2003 2004 2003(In millions)

Projected benefit obligation $307.1 $286.6 $67.3 $72.1 $207.4 $191.0Accumulated benefit obligation 258.5 238.7 52.8 56.4 177.2 160.7Fair value of plan assets 341.4 277.4 — — 154.6 120.9

Other comprehensive loss due to change in minimum liability recognition:

Increase (decrease) in additional minimum liability $ — $ — $ (8.1) $ 9.1 $ (18.7) $ 21.7

(Increase) decrease in intangible asset — — 0.1 (0.5) 0.1 0.5Other comprehensive (income) loss — — (8.0) 8.6 (18.6) 22.2

International pension plans with accumulated benefit obligations in excess of the plans’ assets had aggregate projectedbenefit obligations of $139.4 million and $137.8 million, aggregate accumulated benefit obligations of $120.3 million and $119.1 million and aggregate fair value of plan assets of $85.0 million and $68.9 million at June 30, 2004 and 2003, respectively.

Other thanPension Plans Pension Plans

(In millions)

Expected Cash Flows:Expected employer contributions for year ending June 30, 2005 $ 25.0 $18.0 N/A

Expected benefit payments for year ending June 30,2005 36.3 6.5 $ 2.32006 25.4 7.4 2.42007 28.8 6.3 2.62008 25.3 9.1 2.82009 28.4 9.4 3.1Years 2010 – 2014 184.7 54.7 21.1

Plan Assets:Actual asset allocation

Equity 63% 61% N/AFixed income 32% 37% N/AOther 5% 2% N/A

100% 100% N/A

Target asset allocationEquity 62% 61% N/AFixed income 30% 37% N/AOther 8% 2% N/A

100% 100% N/A

The target policy was set to maximize returns with consideration to the long-term nature of the obligations and main-taining a lower level of overall volatility through the allocation to fixed income. During the year, the asset allocation isreviewed for adherence to the target policy and is rebalanced periodically towards the target weights.


InternationalRestorationRetirement

Growth Account

75


401(k) Savings Plan (U.S.)The Company’s 401(k) Savings Plan (“Savings Plan”) is acontributory defined contribution plan covering substan-tially all regular U.S. employees who have completed thehours and service requirements, as defined by the plandocument. Effective January 1, 2002, regular full-timeemployees are eligible to participate in the Plan on thefirst day of the second month following their date of hire.The Savings Plan is subject to the applicable provisions ofERISA. The Company matches a portion of the partici-pant’s contributions after one year of service under apredetermined formula based on the participant’s contri-bution level and years of service. The Company’s contri-butions were approximately $9.1 million for the fiscalyears ended June 30, 2004 and 2003 and $6.7 million for the fiscal year ended June 30, 2002. Shares of theCompany’s Class A Common Stock are not an investmentoption in the Savings Plan and the Company does not usesuch shares to match participants’ contributions.

Deferred CompensationThe Company accrues for deferred compensation andinterest thereon and for the increase in the value of shareunits pursuant to agreements with a key executive,a former executive and outside directors. The amountsincluded in the accompanying consolidated balancesheets under these plans were $135.4 million and $109.2million as of June 30, 2004 and 2003, respectively.The expense for fiscal 2004, 2003 and 2002 was $16.6million, $17.4 million and $11.6 million, respectively.

NOTE 11– POSTEMPLOYMENT BENEFITS OTHER THAN TO RETIREESThe Company provides certain postemployment benefitsto eligible former or inactive employees and theirdependents during the period subsequent to employ-ment but prior to retirement. These benefits includehealth care coverage and severance benefits. Generally,the cost of providing these benefits is accrued and anyincremental benefits were not material to the Company’sconsolidated financial results.

NOTE 12 – $6.50 CUMULATIVE REDEEMABLEPREFERRED STOCK, AT REDEMPTION VALUEEffective July 1, 2003, in accordance with SFAS No. 150,the $6.50 Cumulative Redeemable Preferred Stock wasreclassified to long-term debt (see Note 8). Such shares ofpreferred stock were exchanged for the 2015 PreferredStock on December 31, 2003.

As of June 30, 2003, the Company’s authorized capitalstock included 23.6 million shares of preferred stock, parvalue $.01 per share, of which 3.6 million shares were out-standing and designated as $6.50 CumulativeRedeemable Preferred Stock. The outstanding preferredstock was issued in June 1995 in exchange for nonvotingcommon stock of the Company then owned by The EstéeLauder 1994 Trust.

Holders of the $6.50 Cumulative Redeemable Pre-ferred Stock were entitled to receive cumulative cash div-idends at a rate of $6.50 per annum per share payable inquarterly installments. Such dividends had preferenceover all other dividends of stock issued by the Company.Shares were subject to mandatory redemption on June30, 2005 at a redemption price of $100 per share. Fol-lowing such date and so long as such mandatory redemp-tion obligations had not been discharged in full, nodividends could be paid or declared upon the Class A orClass B Common Stock, or on any other capital stockranking junior to or in parity with such $6.50 CumulativeRedeemable Preferred Stock and no shares of Class A orClass B Common Stock or such junior or parity stockcould be redeemed or acquired for any consideration bythe Company. Under certain circumstances, the Companycould redeem the stock, in whole or in part, prior to themandatory redemption date. Holders of such stock couldput such shares to the Company at a price of $100 pershare upon the occurrence of certain events.

The Company recorded the $6.50 CumulativeRedeemable Preferred Stock at its redemption value of$360.0 million and charged this amount, net of the parvalue of the shares of nonvoting common stockexchanged, to stockholders’ equity in fiscal 1995.

NOTE 13 – COMMON STOCKAs of June 30, 2004, the Company’s authorized commonstock consists of 650 million shares of Class A CommonStock, par value $.01 per share, and 240 million shares ofClass B Common Stock, par value $.01 per share. Class BCommon Stock is convertible into Class A CommonStock, in whole or in part, at any time and from time totime at the option of the holder, on the basis of one shareof Class A Common Stock for each share of Class B Com-mon Stock converted. Holders of the Company’s Class ACommon Stock are entitled to one vote per share andholders of the Company’s Class B Common Stock areentitled to ten votes per share.

Information about the Company’s common stock out-standing is as follows:

76


Class A Class B(Shares in thousands)

Balance at June 30, 2001 125,176.0 113,490.3Acquisition of treasury stock (1,500.0) —Conversion of Class B to Class A 5,077.8 (5,077.8)Stock option programs 436.3 —

Balance at June 30, 2002 129,190.1 108,412.5Acquisition of treasury stock (11,245.2) —Conversion of Class B to Class A 950.0 (950.0)Share grants 4.0 —Share units converted 0.8 —Stock option programs 1,094.0 —

Balance at June 30, 2003 119,993.7 107,462.5Acquisition of treasury stock (2,832.6) —Conversion of Class B to Class A 14,449.6 (14,449.6)Share grants 2.0 —Stock option programs 2,901.4 —

Balance at June 30, 2004 134,514.1 93,012.9

On September 18, 1998, the Company’s Board of Direc-tors authorized a share repurchase program to repurchasea total of up to 8.0 million shares of Class A CommonStock in the open market or in privately negotiated trans-actions, depending on market conditions and other fac-tors. The Board of Directors authorized the repurchase ofup to 10.0 million additional shares of Class A CommonStock in October 2002 and another 10.0 million in May2004 increasing the total authorization under the sharerepurchase program to 28.0 million shares. As of June 30,2004, approximately 16.7 million shares have been pur-chased under this program.

NOTE 14 – STOCK PROGRAMSThe Company has established the Fiscal 2002 ShareIncentive Plan, the Fiscal 1999 Share Incentive Plan, theFiscal 1996 Share Incentive Plan and the Non-EmployeeDirector Share Incentive Plan (collectively, the “Plans”)and, additionally, has made available stock options andshare units that were, or will be, granted pursuant to thesePlans and certain employment agreements. These stock-based compensation programs are described below.

Total net compensation expense attributable to thegranting of share units and the increase in value of exist-ing share units was $7.8 million and $1.4 million in fiscal2004 and 2003, respectively. Total net compensationincome attributable to the granting of share units and therelated decrease in value of existing share units was $0.2million in fiscal 2002.

Share Incentive PlansThe Plans provide for the issuance of 30,750,000 sharesto be awarded in the form of stock options, stock appre-ciation rights and other stock awards to key employees

and stock options, stock awards and stock units to non-employee directors of the Company. As of June 30, 2004,4,083,900 shares of Class A Common Stock werereserved and were available to be granted pursuant to thePlans. The exercise period for all stock options generallymay not exceed ten years from the date of grant. Pursuantto the Plans, stock option awards in respect of 2,693,500,6,651,200 and 2,175,300 shares were granted in fiscal2004, 2003 and 2002, respectively, and share units inrespect of 62,100, 57,800 and 50,000 shares weregranted in fiscal 2004, 2003 and 2002, respectively.During fiscal 2004, there were no share units convertedwhile in fiscal 2003, approximately 800 share units wereconverted into shares of Class A Common Stock. Duringfiscal 2002, 40,700 share units were cancelled without the issuance of any shares, but the value of such units was transferred to a deferred compensation account.Generally, the stock options become exercisable at vari-ous times through February 2008, while the share unitswill be paid out in shares of Class A Common Stock at atime to be determined by the Company. In the case ofone senior executive, his share units may be converted bythe Company into a cash equivalent amount that wouldbe placed in his deferred compensation account.

In addition to awards made by the Company, certainoutstanding stock options were assumed as part ofthe October 1997 acquisition of Sassaby. Of the 221,200originally issued options to acquire shares of theCompany’s Class A Common Stock, 4,100 were out-standing as of June 30, 2004, all of which were exercis-able and will expire through May 2007.

Executive Employment AgreementsThe executive employment agreements provide for theissuance of 11,400,000 shares to be awarded in the formof stock options and other stock awards to certain keyexecutives. The Company has reserved 660,400 shares ofits Class A Common Stock pursuant to such agreementsas of June 30, 2004. In accordance with such employmentagreements approximately 1,200, 1,400 and 900 shareunits were granted in fiscal 2004, 2003 and 2002, respec-tively. The reserve is solely for dividend equivalents onunits granted pursuant to one of the agreements. Most ofthe stock options granted pursuant to the agreements areexercisable and expire at various times from November2005 through July 2009. The share units may be paid outin shares of Class A Common Stock at a time to be deter-mined by the Company, but no later than 90 days subse-quent to the termination of employment of the executive,or the Company may convert all or some of the shareunits into a cash equivalent amount that would be placedin the executive’s deferred compensation account.

77


A summary of the Company’s stock option programs as of June 30, 2004, 2003 and 2002, and changes during the yearsthen ended, is presented below:

2004 2003 2002

Weighted- Weighted- Weighted-Average Average AverageExercise Exercise Exercise

Shares Price Shares Price Shares Price(Shares in thousands)

Outstanding at beginning of year 29,542.2 $34.93 24,843.5 $35.10 23,393.2 $34.55Granted at fair value 2,693.5 34.77 6,651.2 32.02 2,175.3 39.07Exercised (2,901.4) 21.18 (1,094.0) 15.16 (435.4) 17.85Cancelled or expired (384.5) 39.85 (858.5) 43.10 (289.6) 46.38

Outstanding at end of year 28,949.8 36.23 29,542.2 34.93 24,843.5 35.10

Options exercisable at year-end 19,507.8(a) 36.49 16,425.6 32.31 13,149.5 27.59

Weighted-average fair value ofoptions granted during the year $13.07 $12.35 $16.02

(a) Does not include approximately 1,467,300 shares which will become exercisable on July 1, 2004 due to the retirement of an executive on June 30, 2004,based on the original terms of the option grant.

Summarized information about the Company’s stock options outstanding and exercisable at June 30, 2004 is as follows:

Exercise Price Range Options(a) Average Life(b) Average Price(c) Options(a) Average Price(c)

$ 3.10 4.1 3.3 $3.10 4.1 $3.10$13.00 to $20.813 1,369.3 1.4 13.05 1,369.3 13.05$21.313 to $30.52 5,024.7 3.1 23.89 4,625.4 23.39$31.875 to $47.625 16,313.2 7.0 36.05 7,820.5 37.12$49.75 to $53.50 6,238.5 5.1 51.74 5,688.5 51.93

$ 3.10 to $53.50 28,949.8 36.23 19,507.8 36.49

(a) Shares in thousands.

(b) Weighted average contractual life remaining in years.

(c) Weighted average exercise price.

ExercisableOutstanding

78


NOTE 15 – COMMITMENTS AND CONTINGENCIESTotal rental expense included in the accompanyingconsolidated statements of earnings was $166.8 millionin fiscal 2004, $147.5 million in fiscal 2003 and $142.5million in fiscal 2002. At June 30, 2004, the future mini-mum rental commitments under long-term operatingleases are as follows:

YEAR ENDING JUNE 30 (In millions)

2005 $ 132.82006 122.52007 108.92008 92.62009 80.9Thereafter 464.2

$1,001.9

In July 2003, the Company entered into a settlementagreement with the plaintiffs, the other ManufacturerDefendants (as defined below) and the Department StoreDefendants (as defined below) in a consolidated classaction lawsuit that had been pending in the SuperiorCourt of the State of California in Marin County since1998. In connection with the settlement, the case hasbeen refiled in the United States District Court for theNorthern District of California on behalf of a nationwideclass of consumers of prestige cosmetics in the UnitedStates. The settlement requires Court approval and, ifapproved by the Court, will result in the plaintiffs’ claimsbeing dismissed, with prejudice, in their entirety. Therehas been no finding or admission of any wrongdoing bythe Company in this lawsuit. The Company entered intothe settlement agreement solely to avoid protracted andcostly litigation. In connection with the settlement agree-ment, the defendants, including the Company, will provideconsumers with certain free products and pay the plain-tiffs’ attorneys’ fees. To meet its obligations under the set-tlement, the Company took a special pre-tax charge of$22.0 million, or $13.5 million after tax, equal to $.06 perdiluted common share in the fourth quarter of fiscal 2003.The charge did not have a material adverse effect on theCompany’s consolidated financial condition. In the Fed-eral action, the plaintiffs, purporting to represent a class ofall U.S. residents who purchased prestige cosmetics prod-ucts at retail for personal use from eight departmentstores groups that sold such products in the United States(the “Department Store Defendants”), alleged that theDepartment Store Defendants, the Company and eightother manufacturers of cosmetics (the “ManufacturerDefendants”) conspired to fix and maintain retail pricesand to limit the supply of prestige cosmetics products soldby the Department Store Defendants in violation of state

and Federal laws. The plaintiffs sought, among otherthings, treble damages, equitable relief, attorneys’ fees,interest and costs.

In 1998, the Office of the Attorney General of the Stateof New York (the “State”) notified the Company and tenother entities that they are potentially responsible parties(“PRPs”) with respect to the Blydenburgh landfill in Islip,New York. Each PRP may be jointly and severally liable forthe costs of investigation and cleanup, which the Stateestimates to be $16 million. In 2001, the State sued otherPRPs in the U.S. District Court for the Eastern District ofNew York to recover such costs in connection with thesite. In June 2004, the State added the Company andother PRPs as defendants in this matter. The Companyand certain other PRPs have engaged in settlement dis-cussions which through August 6, 2004 have been unsuc-cessful. The Company intends to vigorously defend thepending claims. While no assurance can be given as tothe ultimate outcome, management believes that the res-olution of the matter will not have a material adverseeffect on the Company’s consolidated financial condition.

In 1998, the State notified the Company and fifteenother entities that they are PRPs with respect to theHuntington/East Northport landfill. The cleanup costs areestimated at $20 million. No litigation has commenced.The Company and other PRPs are in discussions with theState regarding possible settlement of the matter. Whileno assurance can be given as to the ultimate outcome,management believes that the resolution of the matter willnot have a material adverse effect on the Company’s con-solidated financial condition.

In January 2004, the Portuguese Tax Administrationissued a report alleging that a subsidiary of the Companyhad income subject to tax in Portugal for the three fiscalyears ended June 30, 2002. The Company’s subsidiary hasbeen operating in the Madeira Free Trade Zone since1989 under license from the Madeira Development Cor-poration and, in accordance with such license and thelaws of Portugal, the Company believes that its income isnot subject to Portuguese income tax. The subsidiary hasfiled an appeal of the finding to the Portuguese Secretaryof State for Fiscal Matters. As of August 6, 2004, no formaltax assessment has been made. While no assurance canbe given as to the ultimate outcome, managementbelieves that the resolution of the matter will not have amaterial adverse effect on the Company’s consolidatedfinancial condition.

The Company is involved in various routine legal pro-ceedings incident to the ordinary course of its business.In management’s opinion, the outcome of pending legalproceedings, separately and in the aggregate, will not

79


have a material adverse effect on the Company’s businessor consolidated financial results.

NOTE 16 – NET UNREALIZED INVESTMENT GAINSUnder SFAS No. 115, “Accounting for Certain Investmentsin Debt and Equity Securities,” available-for-sale securitiesare recorded at market value. Unrealized holding gainsand losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and arereported as a component of stockholders’ equity untilrealized. The Company’s investments subject to the pro-visions of SFAS No. 115 are treated as available-for-saleand, accordingly, the applicable investments have beenadjusted to market value with a corresponding adjust-ment, net of tax, to net unrealized investment gains inaccumulated other comprehensive income. Included inaccumulated other comprehensive income was an unre-alized investment gain (net of deferred taxes) of $0.1 mil-lion and $0.7 million at June 30, 2004 and 2003,respectively.

NOTE 17 – STATEMENT OF CASH FLOWSSupplemental disclosure of significant non-cash transactionsAs a result of stock option exercises, the Companyrecorded tax benefits of $19.3 million, $7.9 million and$2.9 million during fiscal 2004, 2003 and 2002, respec-tively, which are included in additional paid-in capital inthe accompanying consolidated financial statements.

As of June 30, 2004, the Company had a current liabil-ity and an equal and offsetting decrease in long-term debtof $12.5 million reflecting the fair market value of an inter-est rate swap which was classified as a fair value hedge ofthe 6% Senior Notes (see Note 8). As of June 30, 2003,the Company had a current asset and an equal and offsetting increase in long-term debt of $8.1 millionreflecting the fair market value of an interest rate swapwhich was classified as a fair value hedge of the 6% Senior Notes.

NOTE 18 – SEGMENT DATA AND RELATEDINFORMATIONReportable operating segments, as defined by SFAS No.131, “Disclosures about Segments of an Enterprise andRelated Information,” include components of an enter-prise about which separate financial information is avail-able that is evaluated regularly by the chief operatingdecision maker (the “Chief Executive”) in deciding howto allocate resources and in assessing performance. As aresult of the similarities in the manufacturing, marketingand distribution processes for all of the Company’s prod-ucts, much of the information provided in the con-solidated financial statements is similar to, or the same as,that reviewed on a regular basis by the Chief Executive.Although the Company operates in one businesssegment, beauty products, management also evaluatesperformance on a product category basis.

While the Company’s results of operations are alsoreviewed on a consolidated basis, the Chief Executivereviews data segmented on a basis that facilitates com-parison to industry statistics. Accordingly, net sales, depre-ciation and amortization, and operating income areavailable with respect to the manufacture and distributionof skin care, makeup, fragrance, hair care and other prod-ucts. These product categories meet the FinancialAccounting Standards Board’s definition of operatingsegments and, accordingly, additional financial data areprovided below. The “other” segment includes the salesand related results of ancillary products and services thatdo not fit the definition of skin care, makeup, fragranceand hair care.

The Company evaluates segment performance basedupon operating income, which represents earnings beforeincome taxes, minority interest and net interest income orexpense. The accounting policies for each of thereportable segments are the same as those described inthe summary of significant accounting policies, except fordepreciation and amortization charges, which are allo-cated, primarily, based upon net sales. The assets andliabilities of the Company are managed centrally and arereported internally in the same manner as the consoli-dated financial statements; thus, no additional informationis produced for the Chief Executive or included herein.

80


YEAR ENDED OR AT JUNE 30 2004 2003 2002(In millions)

PRODUCT CATEGORY DATANet Sales:

Skin Care $2,140.1 $1,893.7 $1,703.3Makeup 2,148.3 1,887.8 1,758.3Fragrance 1,221.1 1,059.6 1,017.3Hair Care 249.4 228.9 215.8Other 31.5 26.0 23.0

5,790.4 5,096.0 4,717.7Restructuring — — (6.2)

$5,790.4 $5,096.0 $4,711.5

Depreciation and Amortization:Skin Care $ 68.2 $ 62.2 $ 58.3Makeup 76.9 68.5 59.3Fragrance 39.3 35.5 36.0Hair Care 6.3 7.1 6.5Other 1.0 0.8 1.2

$ 191.7 $ 174.1 $ 161.3

Operating Income:Skin Care $ 336.3 $ 273.2 $ 248.4Makeup 257.7 206.6 183.1Fragrance 24.8 32.1 13.4Hair Care 23.6 14.8 13.7Other 1.6 (1.0) 0.1

644.0 525.7 458.7Reconciliation:Restructuring and special charges — (22.0) (116.6)Interest expense, net (27.1) (8.1) (9.8)

Earnings before income taxes, minority interest and discontinued operations $ 616.9 $ 495.6 $ 332.3

GEOGRAPHIC DATANet Sales:

The Americas $3,148.8 $2,931.8 $2,846.0Europe, the Middle East & Africa 1,870.2 1,506.4 1,261.1Asia/Pacific 771.4 657.8 610.6

5,790.4 5,096.0 4,717.7Restructuring — — (6.2)

$5,790.4 $5,096.0 $4,711.5

Operating Income:The Americas $ 319.2 $ 255.3 $ 222.8Europe, the Middle East & Africa 274.4 227.7 179.9Asia/Pacific 50.4 42.7 56.0

644.0 525.7 458.7Restructuring and special charges — (22.0) (116.6)

$ 644.0 $ 503.7 $ 342.1

Total Assets:The Americas $2,319.3 $2,272.7 $2,467.1Europe, the Middle East & Africa 1,107.1 831.1 703.3Asia/Pacific 281.7 246.1 246.1

$3,708.1 $3,349.9 $3,416.5

Long-Lived Assets (property, plant and equipment):The Americas $ 443.9 $ 446.2 $ 458.4Europe, the Middle East & Africa 170.7 132.2 99.6Asia/Pacific 32.4 29.3 22.7

$ 647.0 $ 607.7 $ 580.7


NOTE 19 – UNAUDITED QUARTERLY FINANCIAL DATAThe following summarizes the unaudited quarterly operating results of the Company for the years ended June 30, 2004and 2003:

September 30 December 31 March 31 June 30 Total Year(In millions, except per share data)

Fiscal 2004Net sales $1,346.6 $1,619.1 $1,421.6 $1,403.1 $5,790.4Gross profit 982.5 1,206.4 1,063.0 1,062.2 4,314.1Operating income 129.7 219.0 169.6 125.7 644.0Net earnings from continuing operations 77.7 126.3 100.1 71.3 375.4

Net earnings 77.0 95.7 98.3 71.1 342.1

Net earnings per common share from continuing operations:

Basic .34 .55 .44 .31 1.65Diluted .34 .54 .43 .31 1.62

Net earnings per common share:Basic .34 .42 .43 .31 1.50Diluted .33 .41 .42 .31 1.48

Fiscal 2003Net sales $1,235.8 $1,407.4 $1,233.5 $1,219.3 $5,096.0Gross profit 881.4 1,038.5 919.7 932.0 3,771.6Operating income 115.6 171.2 129.3 87.6 503.7Net earnings from continuing operations 74.0 110.2 85.0 56.4 325.6

Net earnings 73.4 109.6 83.8 53.0 319.8

Net earnings per common share from continuing operations:

Basic .29 .45 .34 .22 1.30Diluted .29 .44 .34 .22 1.29

Net earnings per common share:Basic .29 .45 .34 .21 1.27Diluted .28 .44 .33 .20 1.26

NOTE 20 – UNAUDITED SUBSEQUENT EVENTOn August 24, 2004, the Company’s Compensation Committee of the Board of Directors approved the conversion of$16.1 million in share units into a cash equivalent amount to be placed in a deferred compensation account. Thisconversion will be reflected in the Company’s first quarter of fiscal 2005 and does not affect the classification of theseshare units as of June 30, 2004.

Pursuant to the Company’s authorized share repurchase program, subsequent to June 30, 2004 and through August 31,2004, the Company purchased an additional 1.3 million shares of Class A Common Stock for $54.9 million bringing thecumulative total of acquired shares to 18.0 million under this program.

Quarter Ended

82


RReeppoorrtt ooff IInnddeeppeennddeenntt RReeggiisstteerreedd PPuubblliicc AAccccoouunnttiinngg FFiirrmm

The Board of Directors and StockholdersThe Estée Lauder Companies Inc.:

We have audited the accompanying consolidated balance sheets of The Estée Lauder Companies Inc. and subsidiaries asof June 30, 2004 and 2003, and the related consolidated statements of earnings, stockholders’ equity and comprehensiveincome and cash flows for each of the years in the three-year period ended June 30, 2004. These consolidated financialstatements are the responsibility of the Company’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financialposition of The Estée Lauder Companies Inc. and subsidiaries as of June 30, 2004 and 2003, and the results of theiroperations and their cash flows for each of the years in the three-year period ended June 30, 2004, in conformity with U.S. generally accepted accounting principles.

As discussed in note 2 to the consolidated financial statements, the Company adopted Statement of Financial AccountingStandards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,”effective July 1, 2003. In addition, as discussed in note 2 to the consolidated financial statements, the Company adoptedStatement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” effective July 1, 2001.

New York, New YorkAugust 6, 2004

83


S TOCKHOLDER INFOR MAT ION

Company HeadquartersThe Estée Lauder Companies Inc.767 Fifth Avenue, New York, New York 10153212-572-4200

Stockholder InformationStockholders may access Company information, includinga summary of the latest financial results, 24 hours a day,by dialing our toll-free information line, 800-308-2334.News releases issued in the last 12 months are availableon the World Wide Web at www.elcompanies.com.

Investor InquiriesWe welcome inquiries from investors, securities analystsand other members of the professional financial community.Please contact the Investor Relations Department in writ-ing at the Company’s headquarters or by telephone at212-572-4384.

Form 10-K Annual ReportIf you would like a copy of the Company’s Annual Reporton Form 10-K, as filed with the Securities and ExchangeCommission, please call the toll-free information line,800-308-2334, or write to the Investor Relations Depart-ment at the Company’s headquarters.

Common Stock InformationThe Class A Common Stock of The Estée Lauder CompaniesInc. is listed on the New York Stock Exchange with thesymbol EL.

Quarterly Per Share Market Prices

Fiscal 2004 Market Price of Common StockQuarter Ended High Low Close

September 30 $37.99 $32.60 $34.10

December 31 40.20 34.21 39.26

March 31 44.58 37.55 44.34

June 30 48.99 43.00 48.78

DividendsDividends on the common stock are expected to be paidannually in January, following declaration by the Board ofDirectors. The last annual dividend was $.30 per share andwas paid in January 2004.

Annual MeetingThe Company’s Annual Meeting of Stockholders will beheld on Friday, November 5, 2004, at 10:00 a.m. at:The Essex House160 Central Park SouthNew York, New York 10019

Attendance at the Annual Meeting will require an admis-sion ticket.

Stockholder ServicesMellon Investor Services is the Company’s transfer agentand registrar. Please contact Mellon directly with allinquiries and requests to:

• Change the name, address or ownership of stock;

• Replace lost certificates or dividend checks;

• Obtain information about dividend reinvestment, directstock purchase or direct deposit of dividends.

Mellon Investor Services LLCP.O. Box 3315South Hackensack, New Jersey 07606888-860-6295www.melloninvestor.com

TrademarksThe Estée Lauder Companies Inc. and its subsidiaries ownnumerous trademarks. Those appearing in the text of thisreport include: A Perfect World, Ab Rescue, Active White,Advanced Night Repair, Advanced Stop Signs, Age Rescue,Air Control, All Over Shimmer, American Beauty, Aramis,Aramis Life, Aromatics Elixir, Aveda, Beautiful, Bobbi Brown,Bobbi Brown Beach, Bobbi Brown Extra, Bumble and bumble,Calm to Your Senses, City Block, Clear Head, Clinique,Clinique CX, Clinique Happy, Clinique Happy Heart, ColorConserve, Color Current, Colour Surge, Convertible Color,Crème Bouquet, Crème de la Mer, Curessence, CurlConscious, Darphin, Darphin Stimulskin Plus, Daywear,Daywear Plus, Dramatically Different, Does It All, Electric,Estée Lauder pleasures, False Eyelashes, Fibre Rich Lash,Flirt!, Frolic, Full Spectrum, Good Skin,™ High Impact,Hydra Complete, Ideal Matte, Idealist, Jo Malone, La Mer,Light Elements, Lab Series for Men, M.A.C, �magic byPrescriptives, MagnaScopic, No Puffery, Origins, Peace ofMind, Perfectionist, Perfectly Real, Pro Lash, Prescriptives,Pure Abundance, Re-Nutriv, Repairwear, Resilience Lift, RichRewards, Rodan + Fields, Sap Moss, Shampure, So Ingenious,Stila, Studio Fix, Super Line Preventor+, Surf Spray, TotalTurnaround, Viva Glam, White Light EX, Youth Dew.

True Star, Tommy Hilfiger, “tommy”, “tommy girl”, “tommy”and “tommy girl” Summer Colognes are licensed trademarksfrom Tommy Hilfiger Licensing Inc. Donna Karan, DonnaKaran Black Cashmere, Donna Karan Cashmere Mist, DonnaKaran Formula Cleaner, Donna Karan Tinted Moisturizer,DKNY the fragrance for Men and DKNY the fragrance forWomen are licensed trademarks from Donna Karan Studio.kate spade beauty, body moisturizer, buttercream, eau deparfum, parfum, soap trio and travel vanity are licensedtrademarks from kate spade LLP. Kors, Michael Kors andMichael are licensed trademarks from Michael Kors L.L.C.

84

Economy & Finance

estee lauder 2004ar